Real-Financial Interaction: A Reconsideration of the Blanchard Model with a State-of-Market Dependent Reaction Coefficient
University of Technology, Sydney, Finance and Economics Working Paper No. 111
38 Pages Posted: 13 Feb 2006
Date Written: March 2001
We reformulate and extend the Blanchard model of output dynamics, the stock market and interest rates that studies Keynesian IS-LM analysis from the perspective of a richer array of short-term bonds. Thus investment demand now depends on Tobin's average q in the place of the real rate of interest and as a result share price dynamics feed back into the real sector, thereby creating the link for the real-financial interaction studied by Blanchard. We reconsider the results achieved by Blanchard without use of logarithms and other simplifications in the expression for the substitutability and imperfect forecasts of capital gains in the place of Blanchard's limit case of perfect substitutes and myopic perfect foresight. Our more general framework, and in particular the assumption of a state-of-the market dependent speed of reaction to expected asset return differentials, allows us to develop a mode of dynamic analysis that provides an alternative to the conventional jump variable technique of the perfect limit cases. We show how as a consequence the stock market dynamics can display periods of bull and bear markets having both activated and tranquil phases that give rise to a variety of adjustment patterns.
Keywords: real-financial interaction, stability, jump variable technique, expectations, phase diagram switching, persistent fluctuations, reaction coefficient, return differential
JEL Classification: E12
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