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Election outcomes and the stockmarket: Further results
European Journal of Political Economy Vol. 13 Ž1997. 143–155
Election outcomes and the stockmarket: Further results Wen-ya Chang b
a,)
, Ching-chong Lai
b
a Department of Economics, Fu-Jen Catholic UniÕersity, Hsinchuang, Taipei 24205, Taiwan Sun Yat-Sen Institute for Social Sciences and Philosophy, Academia Sinica, Nankang, Taipei 11529, Taiwan
Received 15 September 1995; revised 15 April 1996; accepted 15 June 1996
Abstract Based on the Van der Ploeg ŽElection outcomes and the stockmarket, European Journal of Political Economy 5, 21–30, 1989. model embodied with uncertain political outcomes, this paper reexamines the evolutional behavior of the stockmarket value in response to an anticipated fiscal expansion. It is found that a fiscal expansion may lead to a boom in the stockmarket on impact even though the economy is operating in the situation of bad news, and may result in a crash in the stockmarket on impact in the situation of good news. In addition, we also find that the adjustment pattern of the stockmarket value in response to an anticipated fiscal expansion may be misadjusting, even if the system exhibits the saddlepoint stability rather than the global instability as proposed by Aoki ŽMisadjustment to anticipated shocks: An example of exchange-rate response, Journal of International Money and Finance 4, 415–420, 1985.. JEL classification: E30; E62 Keywords: Election outcomes; The stockmarket value; Anticipated fiscal expansion; Misadjustment
1. Introduction In an interesting article recently published in this Journal, Van der Ploeg Ž1989. used the Blanchard Ž1981. model to examine the effects of uncertainty )
Corresponding author.
0176-2680r97r$17.00 Copyright q 1997 Elsevier Science B.V. All rights reserved. PII S 0 1 7 6 - 2 6 8 0 Ž 9 6 . 0 0 0 3 5 - 3
144
W.-y. Chang, C.-c. Lai r European Journal of Political Economy 13 (1997) 143–155
about future political outcomes on the current state of the economy. 1,2 Given that the elasticity of real output demand with respect to the stockmarket value andror the long-run ratio of profits to the stockmarket value are relatively small, Van der Ploeg Ž1989. finds that a fiscal expansion leads to a crash in the stockmarket on impact regardless of whether the shock of fiscal expansion is an unanticipated action or is anticipated with political uncertainty. Based on the Van der Ploeg Ž1989. model, the first purpose of this paper is to show that a fiscal expansion will result in a boom in the stockmarket on impact, if the elasticity of real output demand with respect to the stockmarket value andror the long-run ratio of profits to the stockmarket value are relatively large. Using a modified Dornbusch Ž1976. model, Aoki Ž1985. investigates the exchange-rate responses to anticipated supply shocks. He finds that an entirely different type of exchange rate adjustment pattern – misadjustment path – can arise when economic variables respond to anticipated shocks in perfect foresight models. According to Aoki’s definition, a misadjustment path of exchange rate possesses two features: Ži. the impact adjustment and the long-run adjustment of exchange rate are in opposite direction; Žii. the response of exchange rate during some beginning periods moves further away from its eventual new equilibrium value. 3 Aoki Ž1985, pp. 415–416. further claims that two requirements should be satisfied to establish the misadjustment path: Ži. the dynamic system must have at least two unstable eigenvalues; Žii. the first arrival of the news of a future shock must lead the realization of the shock by more than a minimum of time. 4 Based on the Van der Ploeg Ž1989. framework, the second purpose of this paper is to demonstrate that even if the model exhibits a saddlepoint stability rather than the global instability proposed by Aoki Ž1985., the misadjustment pattern of the real stockprice can be observed in response to an anticipated fiscal expansion. The the paper is organized as follows. The structure of the Van der Ploeg Ž1989. model is outlined in Section 2. Section 3 discusses the feature of the
1 Aoki Ž1986b., Gavin Ž1989., Murphy Ž1989., and Bhandari and Genberg Ž1990. extend the Blanchard Ž1981. model from a closed economy to an open economy, and accordingly examine the effects of monetary and fiscal policies on the dynamics of the exchange rate and the real stockprice. 2 Ž1986. uses the Dornbusch Ž1976. model to illustrate the implications of uncertainty about Gartner ¨ Ž1994. provides an elegant election outcomes on the time profiles of exchange rate. Moreover, Gartner ¨ survey on how macroeconomic analyses of political-economic interaction developed since the 1970s. 3 Aoki Ž1986a,b. uses somewhat complicated models to derive the misadjusting pattern of the exchange rate and of the terms of trade. 4 Aoki Ž1985, p. 419. claimed in his ftnt. 2, ‘‘ . . . the existing literature does not deal adequately with one basic difference between the adjustment paths due to anticipated and unanticipated shocks, because each of the models reported in the literature usually contains only one unstable eigenvalue and adjustment paths generated by dynamics with two unstable roots are not considered. In the former situations, no misadjustment phenomenon can be observed’’. In a different article, Aoki Ž1986b, p. 287, ftnt. 4. made a similar argument. However, we will show below that the misadjustment can arise in a model containing only one unstable eigenvalue.
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145
dynamic system. Section 4 presents a complete dynamic adjustment of the stockmarket value following a fiscal expansion. Section 5 contains concluding remarks.
2. The Van der Ploeg model The Van der Ploeg Ž1989. model can be described by the following five equations: ysaqqf ,
a ) 0,
m y p s ky y ly1 i ,
Ž 1. k , l ) 0,
p˙ s w˙ s f Ž y y y . s f y,
0 - f - k l,
Ž 2. Ž 3.
q˙ e q d s i y p˙ e ' r ,
Ž 4.
dsg Ž yyq. ,
Ž 5.
0 - g - 1,
where, with the exception of nominal interest rate i, dividend ratio d, and real interest rate r, all variables are expressed in logarithms. The variables are defined as follows: y s real output demand, q s the stockmarket value, f s fiscal shock, m s nominal money supply, p s domestic price level, w s nominal wage rate, y s full-employment output Žs 0., an overdot denotes the time derivative and a superscript ‘e’ denotes the expected rate. Eqs. Ž1. and Ž2. state the IS and the LM relation respectively. Eq. Ž3. is a simple form of price adjustment in terms of the Phillips curve relationship, with prices responding to excess demand for goods. 5 Eq. Ž4. describes the efficient arbitrage condition in financial markets as bonds and stocks Žshares. are perfect substitutes. Eq. Ž5. states that the dividend ratio is an increasing function of the ratio of output to the stockmarket value. 6
3. The feature of dynamics In the absence of uncertainty about political election, the assumption of rational expectations implies that q˙ e s q˙ and p˙ e s p. ˙ From Eqs. Ž1. – Ž5. we have p˙ 0 s l q˙
fa ff p q q Da q g Df
Ž 6.
5 Eq. Ž3. can be justified by the behavior of firms, labor, and contract-setting developed by Gray Ž1976. and Fischer Ž1977.. 6 The detailed explanation for Eqs. Ž4. and Ž5. is provided by Blanchard Ž1981..
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W.-y. Chang, C.-c. Lai r European Journal of Political Economy 13 (1997) 143–155
Fig. 1.
where D s l k y f y g c 0. Note that, if g is relatively small, D ) 0 and hence Da q g ) 0; 7 if g is relatively large, D - 0 but Da q g c 0 depending upon the size of Da and g . Let S1 and S2 be two characteristic roots of Eq. Ž6.. We then have S1 S2 s ylfa - 0. Evidently, the two roots of the dynamic system will be of opposite sign, implying that the system displays the saddlepoint stability. The evolution of the system can be described by means of a phase diagram like Fig. 1. It is clear from Eq. Ž6. that the slopes of loci p˙ s 0 and q˙ s 0 are
Eq Ep
s 0,
Eq Ep
Ž 7.
ps ˙ 0
l sy qs ˙ 0
Da q g
c 0 as Da q g b 0.
Ž 8.
Apparently, the slope of the q˙ s 0 locus depends on the sign of Da q g . The economic explanation for the sign of Da q g can be put straightforwardly as follows. The rise in real stockprice directly leads to an increase in output and a decrease in the dividend ratio. The former will raise both the nominal interest rate via the transaction demand for money and the actual rate of change of the domestic price via the Phillips curve. As assumed in the Van der Ploeg Ž1989. model, the rise in nominal interest rate will dominate the rise in rate of change of 7
The Van der Ploeg Ž1989. analysis implicitly assumes such a case.
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147
domestic price, and hence the real interest rate is increased. 8 Meanwhile, as the increased output will raise the dividend ratio on the other hand, the net effect of dividend ratio thus is ambiguous, depending on the elasticity of real output demand with respect to the stockmarket value Ž a .. Accordingly, following the Blanchard Ž1981. and Gavin Ž1989. terminology, in what follows we define the bad news case as the situation where the effect of real interest rate dominates the effect of dividend ratio Ž Da q g ) 0.. On the other hand, the good news case refers to the situation where the dividend ratio effect surmounts the real interest effect Ž Da q g - 0.. Panels a and b of Fig. 1 correspond to bad news and good news, respectively. As indicated by the direction of the arrows in both panels of Fig. 1, the lines SS and UU represent the stable and unstable branches, respectively. The stable arm SS is downward sloping, while the divergent branch UU is upward sloping regardless of the slope of the q˙ s 0 locus.
4. Adjustment process We now study the adjustment process of the economy, in which at time t s 0 the authorities announce the government spending will increase from f 0 to f T at a specific date t s T in the future. Before we proceed with the analysis, two points should be noted. First, for expository convenience, in what follows, 0q denotes the instant after the announcement made by the authorities, and Ty and Tq denote the instant before and after policy implementation, respectively. Second, since the public become aware that the government spending will increase from f 0 to f T at the moment of Tq, the economy should move to a point exactly on the stable arm SS at that instant of time in order to ensure the system to be convergent. As D does not possess a definite sign, the bad news situation thus has two possibilities. Fig. 2 illustrates the bad news situation with which Van der Ploeg Ž1989. is concerned: D ) 0 and Da q g ) 0. 9 The initial equilibrium, where p˙ s 0Ž f 0 . and q˙ s 0Ž f 0 . intersect, is at E 0 ; the initial domestic price and the real stockprice are p 0 and q0 , respectively. Upon the shock of a fiscal expansion, both p˙ s 0Ž f 0 . and q˙ s 0Ž f 0 . shift downwards to p˙ s 0Ž f T . and q˙ s 0Ž f T ., but the 8 From Eqs. Ž1. and Ž2., we have the following instantaneous relationships: ys aqq f , is lw k Ž a q q f . q py m x . According to the definition of real interest rate ŽEq. Ž4.. and using Eq. Ž3. and the above instantaneous relations, we have: r s Ž l k y f . a q q l pq Ž l k y f . f y l m. As Van der Ploeg Ž1989. assumes f - l k Žsee Eq. Ž3.., the real interest rate will increase in response to the rise in real stockprice. 9 We can rewrite Da qg as Ž l k y f . a qŽ1y a .g . Obviously, if the elasticity of real output demand with respect to the stockmarket value is inelastic Ž a -1., Da qg ) 0 is true.
148
W.-y. Chang, C.-c. Lai r European Journal of Political Economy 13 (1997) 143–155
Fig. 2.
p˙ s 0 locus shifts by more than q˙ s 0 shifts. 10 The new long-run equilibrium is at point E ) , and the new stationary value of domestic price pˆ is greater than p 0 , while the real stockprice qˆ is smaller than q0 . During the time interval between times 0 and Ty, the government spending does not as yet expand and thus the point E 0 should be treated as the reference point to govern the dynamic adjustment of p and q. Consequently, at the instant of anticipated fiscal announcement, the stockmarket value at once falls from q0 to q0q, while the domestic price remains intact at its initial level p 0 . The discrete adjustment in q leads the economy to jump from E 0 to E 0q. From 0q to Ty, as arrows indicate, both q and p continue to decrease, and the economy moves from E 0q to E T . At time Tq, with a fiscal expansion enacted, the economy exactly reaches the point E T on the stable arm SS. Thereafter, from Tq onwards, q continues to fall and p turns to rise as the economy moves along SS towards its new long-run equilibrium E ) . Panels a and b of Fig. 3 illustrate the other bad news situation with which Van der Ploeg Ž1989. does not deal: D - 0 and Da q g ) 0. This situation implies that the ratio of profits to the stockmarket value Žg . is relatively large but the elasticity 10
It is clear from Eq. Ž6. that: E qrE f p˙ s 0 sy1r a - 0, E qrE f q˙ s 0 sy D r Ž Da qg . - 0. Then, a comparison of the above relationships gives E qrE f < ps . ˙ 0 ) E qrE f < qs0 ˙
W.-y. Chang, C.-c. Lai r European Journal of Political Economy 13 (1997) 143–155
149
Fig. 3.
of real output demand with respect to the stockmarket value Ž a . is relatively small. The initial equilibrium E 0 is the same as that of Fig. 2. Following a fiscal expansion, p˙ s 0Ž f 0 . shifts downwards to p˙ s 0Ž f T . but q˙ s 0Ž f 0 . shifts upwards to q˙ s 0Ž f T .. 11 The new steady state E ) is characterized by a higher domestic 11
From footnote 10 with D - 0 and Da qg ) 0, E qrE f < qs ˙ 0 sy D rŽ Da qg . ) 0.
150
W.-y. Chang, C.-c. Lai r European Journal of Political Economy 13 (1997) 143–155
Fig. 4.
price and a lower stockmarket value. As a result, the line connecting the initial steady state ŽE 0 . and the new steady state ŽE ) ., namely the LL schedule, is always downward sloping. In addition, panel a of Fig. 1 reveals that the stable arm SS is also downward sloping. Accordingly, two cases may happen. 12 Panel a of
12
The detailed mathematical derivations for dynamic adjustment are available upon request from the authors.
W.-y. Chang, C.-c. Lai r European Journal of Political Economy 13 (1997) 143–155
151
Fig. 5.
Fig. 3 depicts the situation where the LL line is flatter than the SS curve; while panel b of Fig. 3 portrays the situation where the LL line is steeper than SS. In panel a of Fig. 3a, following the same description as that in Fig. 2, at the instant 0q, the stockmarket value will instantaneously rise from q0 to q0q, making the economy jump from the point E 0 to E 0q on impact. During the period prior to the fiscal expansion, the economy is characterized by an increase in both q and p. At time Tq, when a fiscal expansion is implemented, the economy exactly reaches a point like E T on the stable arm SS. Thereafter, from Tq onwards, the domestic price continues to rise and the stockmarket value turns to fall as the economy moves along SS towards its new steady state E ) . Obviously, the adjustment pattern of the stockmarket value is entirely consistent with the Aoki Ž1985. definition on misadjustment. 13 This result contrasts with the bad news case of Blanchard Ž1981.. On the other hand, panel b of Fig. 3 corresponds to the case that the LL line is steeper than the stable branch SS. Since the adjustment pattern of the real
13 The direction of impact response of the stockmarket value is opposite to that of the long-run response, and the adjustment of the stockmarket value during dates between 0q and Ty moves further away from its new steady state value.
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W.-y. Chang, C.-c. Lai r European Journal of Political Economy 13 (1997) 143–155
stockprice is similar to that displayed in Fig. 2, we only present the graphical result to save space. The graphical analyses in panels a and b of Fig. 3 tell us that, even though the dynamic system is characterized by the saddlepoint stability, the misadjustment phenomenon will arise if the line connecting the long-run equilibrium states is flatter than the stable arm. This conclusion runs in sharp contrast with the Aoki Ž1985. result, which claims that the misadjustment can occur only when the economy is characterized by the global instability. The economic explanation underlying the results in both panels of Fig. 3 is as follows. The relative slopes of the stable arm and the line connecting the initial and the new steady states, indicate the stockmarket value on the stable arm is higher or lower than that on the LL line. Moreover, to ensure the system to be convergent and rule out anticipated asset price jumps, the economy must be at the SS curve when the fiscal expansion is enacted. As a consequence, when the SS curve is steeper than the LL line which indicates the stockmarket value on the SS curve is higher, the stockmarket value must rise on impact and then continues to rise in order to ensure the economy to land on SS at the moment of Tq. Otherwise, when the SS curve is flatter than the LL line which indicates the stockmarket value on the SS curve is lower, the stockmarket value must fall on impact and then continues to fall in order to ensure the economy to land on SS at time Tq. The good news situation is illustrated in both panels of Fig. 4. Similar consideration and illustration can be applied to the case of good news. 14 To save space, we only present the graphical results in both panels of Fig. 4. Moreover, in order to sharpen the different results under alternative situations, we summarize the analytical outcomes of an anticipated fiscal expansion in Table 1. 15 We are now in a position to consider the uncertainty about future political outcomes. Following Van der Ploeg Ž1989., assume that an incumbent Conservative administration at time 0 is facing an election in T intervals, while the rival Labour party promises to expand fiscal spending f T if it is elected to office. Let p be the probability that the Conservative party is reelected and Ž1 y p . be the probability that the Labour party wins the election. Accordingly, the private sector anticipates a fiscal expansion with an expected value of f e ws p f 0 q Ž1 y p . f T x in the pre-election period. To save space, we only present one of the contrasting cases: D - 0, Da q g ) 0 and LL line flatter than SS. 16 In Fig. 5, at the instant
14
In the good news case, in response to an anticipated fiscal expansion, both ps ˙ 0 and q˙ s 0 loci shift downwards, but q˙ s 0 shifts by more than ps ˙ 0, which can be easily inferred from footnote 10 with D - 0 and Da qg - 0. Under such a situation, similar to panels a and b of Fig. 3, two cases may happen too. Panel a of Fig. 4 depicts the situation where the LL line is flatter than the stable branch SS, while panel b of Fig. 4 describes the situation where the LL line is steeper than SS. 15 This suggestion was proposed by an anonymous referee, to whom we are grateful. 16 Combining the uncertainty of future political outcomes with the analyses of panels a and b of Fig. 4 will lead to dissimilar results from the Van der Ploeg Ž1989. analysis.
Diagram
Van der Ploeg’s Ž1989. result
Literature comparison
q first decreases then increases, q decreases, p increases Fig. 4, panel a opposite to Van der Ploeg Ž1989. p increases and Blanchard Ž1981. q first increases then decreases, q decreases, p increases Fig. 4, panel b opposite to Van der Ploeg Ž1989. p decreases and Blanchard Ž1981.
LL is steeper than SS q falls
q decreases, p increases Fig. 3, panel b Van der Ploeg’s Ž1989. result
q decreases, p increases Fig. 3, panel a opposite to Van der Ploeg Ž1989. and Blanchard Ž1981.
q decreases, p increases Fig. 2
After fiscal expansion
q rises
Good news Da qg - 0 D - 0 LL is flatter than SS
q decreases, p decreases
LL is steeper than SS q falls
q decreases, p decreases
q increases, p increases
q falls
Impact Before fiscal expansion response
q rises
D - 0 LL is flatter than SS
Bad news Da qg ) 0 D) 0
Cases
Table 1 Alternative adjustment patterns of anticipated fiscal expansion
W.-y. Chang, C.-c. Lai r European Journal of Political Economy 13 (1997) 143–155 153
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W.-y. Chang, C.-c. Lai r European Journal of Political Economy 13 (1997) 143–155
0q, an anticipated election of the Labour party causes the stockmarket value to rise from q0 to q0q so as to cause the economy to jump from the point E 0 to E 0q on impact. During the period from the run-up to the election eve, both q and p continue to increase, and the economy moves from E 0q to E e. On the morning after the election, the news of the election outcome will cause a discontinuous jump in the stockmarket value. 17 If the Conservative party is re-elected, the stockmarket value at once falls and the economy jumps from E e to E C on the stable arm SS C . Thereafter, the stockmarket value rises and the domestic price falls as the economy moves along SS C towards its long-run equilibrium E 0 . However, if the Labour party is elected to office and a fiscal expansion is enacted, the stockmarket value immediately rises and the economy jumps from E e to E L on the stable arm SS L . Thereafter, the stockmarket value turns to fall and the domestic price continues to rise as the economy moves along SS L towards its new steady state E ) .
5. Concluding remarks Based on the Van der Ploeg Ž1989. model, this paper has analyzed the evolutional behavior of the stockmarket value and domestic prices following an anticipated fiscal expansion. Two central conclusions emerge from the analysis. First, a fiscal expansion may lead to a boom in the stockmarket on impact even though the economy is operating in the situation of bad news, and may result in a crash in the stockmarket on impact in the context of good news case. Second, the adjustment pattern of the stockmarket value in response to an anticipated fiscal expansion may be misadjusting, even if the system exhibits saddlepoint stability rather than the global instability as proposed by Aoki Ž1985..
Acknowledgements The authors are grateful to the editor of this journal, Heinrich W. Ursprung, and two anonymous referees for their stimulating suggestions and helpful comments on an earlier version of the paper. We alone are responsible for all the views and remaining errors herein.
17
Ž1986, p. 158. offers an excellent interpretation of a scheduled election as an announced Gartner ¨ policy change, and of an election result as a surprise policy change.
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References Aoki, M., 1985, Misadjustment to anticipated shocks: An example of exchange-rate response, Journal of International Money and Finance 4, 415–420. Aoki, M., 1986a, Dynamic adjustment behaviour to anticipated supply shocks in a two-country model, Economic Journal 96, 80–100. Aoki, M., 1986b, Effects of anticipated central bank actions on Tobin’s Q, share prices and exchange rate in a small open economy, European Economic Review 30, 285–304. Bhandari, J.S. and H. Genberg, 1990, Exchange rate movements and international interdependence of stock markets, Kredit und Kapital 23, 496–531. Blanchard, O.J., 1981, Output, the stock market, and interest rates, American Economic Review 71, 132–143. Dornbusch, R., 1976, Expectations and exchange rate dynamics, Journal of Political Economy 84, 1161–1176. Fischer, S., 1977, Wage indexation and macroeconomic stability, In: K. Brunner and A. Meltzer, eds., Stabilization of the domestic and international economy ŽNorth-Holland, Amsterdam.. Gartner, M., 1986, Some political economy of flexible exchange rates, European Journal of Political ¨ Economy 2, 153–168. Gartner, M., 1994, Democracy, elections, and macroeconomic policy: Two decades of progress, ¨ European Journal of Political Economy 10, 85–109. Gavin, M., 1989, The stock market and exchange rate dynamics, Journal of International Money and Finance 8, 181–200. Gray, J.A., 1976, Wage indexation: A macroeconomic approach, Journal of Monetary Economics 2, 231–235. Murphy, R.G., 1989, Stock prices, real exchange rates, and optimal capital accumulation, IMF Staff Papers 36, 102–128. Van der Ploeg, F., 1989, Election outcomes and the stockmarket, European Journal of Political Economy 5, 21–30.
Election outcomes and the stockmarket: Further results Wen-ya Chang b
a,)
, Ching-chong Lai
b
a Department of Economics, Fu-Jen Catholic UniÕersity, Hsinchuang, Taipei 24205, Taiwan Sun Yat-Sen Institute for Social Sciences and Philosophy, Academia Sinica, Nankang, Taipei 11529, Taiwan
Received 15 September 1995; revised 15 April 1996; accepted 15 June 1996
Abstract Based on the Van der Ploeg ŽElection outcomes and the stockmarket, European Journal of Political Economy 5, 21–30, 1989. model embodied with uncertain political outcomes, this paper reexamines the evolutional behavior of the stockmarket value in response to an anticipated fiscal expansion. It is found that a fiscal expansion may lead to a boom in the stockmarket on impact even though the economy is operating in the situation of bad news, and may result in a crash in the stockmarket on impact in the situation of good news. In addition, we also find that the adjustment pattern of the stockmarket value in response to an anticipated fiscal expansion may be misadjusting, even if the system exhibits the saddlepoint stability rather than the global instability as proposed by Aoki ŽMisadjustment to anticipated shocks: An example of exchange-rate response, Journal of International Money and Finance 4, 415–420, 1985.. JEL classification: E30; E62 Keywords: Election outcomes; The stockmarket value; Anticipated fiscal expansion; Misadjustment
1. Introduction In an interesting article recently published in this Journal, Van der Ploeg Ž1989. used the Blanchard Ž1981. model to examine the effects of uncertainty )
Corresponding author.
0176-2680r97r$17.00 Copyright q 1997 Elsevier Science B.V. All rights reserved. PII S 0 1 7 6 - 2 6 8 0 Ž 9 6 . 0 0 0 3 5 - 3
144
W.-y. Chang, C.-c. Lai r European Journal of Political Economy 13 (1997) 143–155
about future political outcomes on the current state of the economy. 1,2 Given that the elasticity of real output demand with respect to the stockmarket value andror the long-run ratio of profits to the stockmarket value are relatively small, Van der Ploeg Ž1989. finds that a fiscal expansion leads to a crash in the stockmarket on impact regardless of whether the shock of fiscal expansion is an unanticipated action or is anticipated with political uncertainty. Based on the Van der Ploeg Ž1989. model, the first purpose of this paper is to show that a fiscal expansion will result in a boom in the stockmarket on impact, if the elasticity of real output demand with respect to the stockmarket value andror the long-run ratio of profits to the stockmarket value are relatively large. Using a modified Dornbusch Ž1976. model, Aoki Ž1985. investigates the exchange-rate responses to anticipated supply shocks. He finds that an entirely different type of exchange rate adjustment pattern – misadjustment path – can arise when economic variables respond to anticipated shocks in perfect foresight models. According to Aoki’s definition, a misadjustment path of exchange rate possesses two features: Ži. the impact adjustment and the long-run adjustment of exchange rate are in opposite direction; Žii. the response of exchange rate during some beginning periods moves further away from its eventual new equilibrium value. 3 Aoki Ž1985, pp. 415–416. further claims that two requirements should be satisfied to establish the misadjustment path: Ži. the dynamic system must have at least two unstable eigenvalues; Žii. the first arrival of the news of a future shock must lead the realization of the shock by more than a minimum of time. 4 Based on the Van der Ploeg Ž1989. framework, the second purpose of this paper is to demonstrate that even if the model exhibits a saddlepoint stability rather than the global instability proposed by Aoki Ž1985., the misadjustment pattern of the real stockprice can be observed in response to an anticipated fiscal expansion. The the paper is organized as follows. The structure of the Van der Ploeg Ž1989. model is outlined in Section 2. Section 3 discusses the feature of the
1 Aoki Ž1986b., Gavin Ž1989., Murphy Ž1989., and Bhandari and Genberg Ž1990. extend the Blanchard Ž1981. model from a closed economy to an open economy, and accordingly examine the effects of monetary and fiscal policies on the dynamics of the exchange rate and the real stockprice. 2 Ž1986. uses the Dornbusch Ž1976. model to illustrate the implications of uncertainty about Gartner ¨ Ž1994. provides an elegant election outcomes on the time profiles of exchange rate. Moreover, Gartner ¨ survey on how macroeconomic analyses of political-economic interaction developed since the 1970s. 3 Aoki Ž1986a,b. uses somewhat complicated models to derive the misadjusting pattern of the exchange rate and of the terms of trade. 4 Aoki Ž1985, p. 419. claimed in his ftnt. 2, ‘‘ . . . the existing literature does not deal adequately with one basic difference between the adjustment paths due to anticipated and unanticipated shocks, because each of the models reported in the literature usually contains only one unstable eigenvalue and adjustment paths generated by dynamics with two unstable roots are not considered. In the former situations, no misadjustment phenomenon can be observed’’. In a different article, Aoki Ž1986b, p. 287, ftnt. 4. made a similar argument. However, we will show below that the misadjustment can arise in a model containing only one unstable eigenvalue.
W.-y. Chang, C.-c. Lai r European Journal of Political Economy 13 (1997) 143–155
145
dynamic system. Section 4 presents a complete dynamic adjustment of the stockmarket value following a fiscal expansion. Section 5 contains concluding remarks.
2. The Van der Ploeg model The Van der Ploeg Ž1989. model can be described by the following five equations: ysaqqf ,
a ) 0,
m y p s ky y ly1 i ,
Ž 1. k , l ) 0,
p˙ s w˙ s f Ž y y y . s f y,
0 - f - k l,
Ž 2. Ž 3.
q˙ e q d s i y p˙ e ' r ,
Ž 4.
dsg Ž yyq. ,
Ž 5.
0 - g - 1,
where, with the exception of nominal interest rate i, dividend ratio d, and real interest rate r, all variables are expressed in logarithms. The variables are defined as follows: y s real output demand, q s the stockmarket value, f s fiscal shock, m s nominal money supply, p s domestic price level, w s nominal wage rate, y s full-employment output Žs 0., an overdot denotes the time derivative and a superscript ‘e’ denotes the expected rate. Eqs. Ž1. and Ž2. state the IS and the LM relation respectively. Eq. Ž3. is a simple form of price adjustment in terms of the Phillips curve relationship, with prices responding to excess demand for goods. 5 Eq. Ž4. describes the efficient arbitrage condition in financial markets as bonds and stocks Žshares. are perfect substitutes. Eq. Ž5. states that the dividend ratio is an increasing function of the ratio of output to the stockmarket value. 6
3. The feature of dynamics In the absence of uncertainty about political election, the assumption of rational expectations implies that q˙ e s q˙ and p˙ e s p. ˙ From Eqs. Ž1. – Ž5. we have p˙ 0 s l q˙
fa ff p q q Da q g Df
Ž 6.
5 Eq. Ž3. can be justified by the behavior of firms, labor, and contract-setting developed by Gray Ž1976. and Fischer Ž1977.. 6 The detailed explanation for Eqs. Ž4. and Ž5. is provided by Blanchard Ž1981..
146
W.-y. Chang, C.-c. Lai r European Journal of Political Economy 13 (1997) 143–155
Fig. 1.
where D s l k y f y g c 0. Note that, if g is relatively small, D ) 0 and hence Da q g ) 0; 7 if g is relatively large, D - 0 but Da q g c 0 depending upon the size of Da and g . Let S1 and S2 be two characteristic roots of Eq. Ž6.. We then have S1 S2 s ylfa - 0. Evidently, the two roots of the dynamic system will be of opposite sign, implying that the system displays the saddlepoint stability. The evolution of the system can be described by means of a phase diagram like Fig. 1. It is clear from Eq. Ž6. that the slopes of loci p˙ s 0 and q˙ s 0 are
Eq Ep
s 0,
Eq Ep
Ž 7.
ps ˙ 0
l sy qs ˙ 0
Da q g
c 0 as Da q g b 0.
Ž 8.
Apparently, the slope of the q˙ s 0 locus depends on the sign of Da q g . The economic explanation for the sign of Da q g can be put straightforwardly as follows. The rise in real stockprice directly leads to an increase in output and a decrease in the dividend ratio. The former will raise both the nominal interest rate via the transaction demand for money and the actual rate of change of the domestic price via the Phillips curve. As assumed in the Van der Ploeg Ž1989. model, the rise in nominal interest rate will dominate the rise in rate of change of 7
The Van der Ploeg Ž1989. analysis implicitly assumes such a case.
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domestic price, and hence the real interest rate is increased. 8 Meanwhile, as the increased output will raise the dividend ratio on the other hand, the net effect of dividend ratio thus is ambiguous, depending on the elasticity of real output demand with respect to the stockmarket value Ž a .. Accordingly, following the Blanchard Ž1981. and Gavin Ž1989. terminology, in what follows we define the bad news case as the situation where the effect of real interest rate dominates the effect of dividend ratio Ž Da q g ) 0.. On the other hand, the good news case refers to the situation where the dividend ratio effect surmounts the real interest effect Ž Da q g - 0.. Panels a and b of Fig. 1 correspond to bad news and good news, respectively. As indicated by the direction of the arrows in both panels of Fig. 1, the lines SS and UU represent the stable and unstable branches, respectively. The stable arm SS is downward sloping, while the divergent branch UU is upward sloping regardless of the slope of the q˙ s 0 locus.
4. Adjustment process We now study the adjustment process of the economy, in which at time t s 0 the authorities announce the government spending will increase from f 0 to f T at a specific date t s T in the future. Before we proceed with the analysis, two points should be noted. First, for expository convenience, in what follows, 0q denotes the instant after the announcement made by the authorities, and Ty and Tq denote the instant before and after policy implementation, respectively. Second, since the public become aware that the government spending will increase from f 0 to f T at the moment of Tq, the economy should move to a point exactly on the stable arm SS at that instant of time in order to ensure the system to be convergent. As D does not possess a definite sign, the bad news situation thus has two possibilities. Fig. 2 illustrates the bad news situation with which Van der Ploeg Ž1989. is concerned: D ) 0 and Da q g ) 0. 9 The initial equilibrium, where p˙ s 0Ž f 0 . and q˙ s 0Ž f 0 . intersect, is at E 0 ; the initial domestic price and the real stockprice are p 0 and q0 , respectively. Upon the shock of a fiscal expansion, both p˙ s 0Ž f 0 . and q˙ s 0Ž f 0 . shift downwards to p˙ s 0Ž f T . and q˙ s 0Ž f T ., but the 8 From Eqs. Ž1. and Ž2., we have the following instantaneous relationships: ys aqq f , is lw k Ž a q q f . q py m x . According to the definition of real interest rate ŽEq. Ž4.. and using Eq. Ž3. and the above instantaneous relations, we have: r s Ž l k y f . a q q l pq Ž l k y f . f y l m. As Van der Ploeg Ž1989. assumes f - l k Žsee Eq. Ž3.., the real interest rate will increase in response to the rise in real stockprice. 9 We can rewrite Da qg as Ž l k y f . a qŽ1y a .g . Obviously, if the elasticity of real output demand with respect to the stockmarket value is inelastic Ž a -1., Da qg ) 0 is true.
148
W.-y. Chang, C.-c. Lai r European Journal of Political Economy 13 (1997) 143–155
Fig. 2.
p˙ s 0 locus shifts by more than q˙ s 0 shifts. 10 The new long-run equilibrium is at point E ) , and the new stationary value of domestic price pˆ is greater than p 0 , while the real stockprice qˆ is smaller than q0 . During the time interval between times 0 and Ty, the government spending does not as yet expand and thus the point E 0 should be treated as the reference point to govern the dynamic adjustment of p and q. Consequently, at the instant of anticipated fiscal announcement, the stockmarket value at once falls from q0 to q0q, while the domestic price remains intact at its initial level p 0 . The discrete adjustment in q leads the economy to jump from E 0 to E 0q. From 0q to Ty, as arrows indicate, both q and p continue to decrease, and the economy moves from E 0q to E T . At time Tq, with a fiscal expansion enacted, the economy exactly reaches the point E T on the stable arm SS. Thereafter, from Tq onwards, q continues to fall and p turns to rise as the economy moves along SS towards its new long-run equilibrium E ) . Panels a and b of Fig. 3 illustrate the other bad news situation with which Van der Ploeg Ž1989. does not deal: D - 0 and Da q g ) 0. This situation implies that the ratio of profits to the stockmarket value Žg . is relatively large but the elasticity 10
It is clear from Eq. Ž6. that: E qrE f p˙ s 0 sy1r a - 0, E qrE f q˙ s 0 sy D r Ž Da qg . - 0. Then, a comparison of the above relationships gives E qrE f < ps . ˙ 0 ) E qrE f < qs0 ˙
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149
Fig. 3.
of real output demand with respect to the stockmarket value Ž a . is relatively small. The initial equilibrium E 0 is the same as that of Fig. 2. Following a fiscal expansion, p˙ s 0Ž f 0 . shifts downwards to p˙ s 0Ž f T . but q˙ s 0Ž f 0 . shifts upwards to q˙ s 0Ž f T .. 11 The new steady state E ) is characterized by a higher domestic 11
From footnote 10 with D - 0 and Da qg ) 0, E qrE f < qs ˙ 0 sy D rŽ Da qg . ) 0.
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Fig. 4.
price and a lower stockmarket value. As a result, the line connecting the initial steady state ŽE 0 . and the new steady state ŽE ) ., namely the LL schedule, is always downward sloping. In addition, panel a of Fig. 1 reveals that the stable arm SS is also downward sloping. Accordingly, two cases may happen. 12 Panel a of
12
The detailed mathematical derivations for dynamic adjustment are available upon request from the authors.
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151
Fig. 5.
Fig. 3 depicts the situation where the LL line is flatter than the SS curve; while panel b of Fig. 3 portrays the situation where the LL line is steeper than SS. In panel a of Fig. 3a, following the same description as that in Fig. 2, at the instant 0q, the stockmarket value will instantaneously rise from q0 to q0q, making the economy jump from the point E 0 to E 0q on impact. During the period prior to the fiscal expansion, the economy is characterized by an increase in both q and p. At time Tq, when a fiscal expansion is implemented, the economy exactly reaches a point like E T on the stable arm SS. Thereafter, from Tq onwards, the domestic price continues to rise and the stockmarket value turns to fall as the economy moves along SS towards its new steady state E ) . Obviously, the adjustment pattern of the stockmarket value is entirely consistent with the Aoki Ž1985. definition on misadjustment. 13 This result contrasts with the bad news case of Blanchard Ž1981.. On the other hand, panel b of Fig. 3 corresponds to the case that the LL line is steeper than the stable branch SS. Since the adjustment pattern of the real
13 The direction of impact response of the stockmarket value is opposite to that of the long-run response, and the adjustment of the stockmarket value during dates between 0q and Ty moves further away from its new steady state value.
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stockprice is similar to that displayed in Fig. 2, we only present the graphical result to save space. The graphical analyses in panels a and b of Fig. 3 tell us that, even though the dynamic system is characterized by the saddlepoint stability, the misadjustment phenomenon will arise if the line connecting the long-run equilibrium states is flatter than the stable arm. This conclusion runs in sharp contrast with the Aoki Ž1985. result, which claims that the misadjustment can occur only when the economy is characterized by the global instability. The economic explanation underlying the results in both panels of Fig. 3 is as follows. The relative slopes of the stable arm and the line connecting the initial and the new steady states, indicate the stockmarket value on the stable arm is higher or lower than that on the LL line. Moreover, to ensure the system to be convergent and rule out anticipated asset price jumps, the economy must be at the SS curve when the fiscal expansion is enacted. As a consequence, when the SS curve is steeper than the LL line which indicates the stockmarket value on the SS curve is higher, the stockmarket value must rise on impact and then continues to rise in order to ensure the economy to land on SS at the moment of Tq. Otherwise, when the SS curve is flatter than the LL line which indicates the stockmarket value on the SS curve is lower, the stockmarket value must fall on impact and then continues to fall in order to ensure the economy to land on SS at time Tq. The good news situation is illustrated in both panels of Fig. 4. Similar consideration and illustration can be applied to the case of good news. 14 To save space, we only present the graphical results in both panels of Fig. 4. Moreover, in order to sharpen the different results under alternative situations, we summarize the analytical outcomes of an anticipated fiscal expansion in Table 1. 15 We are now in a position to consider the uncertainty about future political outcomes. Following Van der Ploeg Ž1989., assume that an incumbent Conservative administration at time 0 is facing an election in T intervals, while the rival Labour party promises to expand fiscal spending f T if it is elected to office. Let p be the probability that the Conservative party is reelected and Ž1 y p . be the probability that the Labour party wins the election. Accordingly, the private sector anticipates a fiscal expansion with an expected value of f e ws p f 0 q Ž1 y p . f T x in the pre-election period. To save space, we only present one of the contrasting cases: D - 0, Da q g ) 0 and LL line flatter than SS. 16 In Fig. 5, at the instant
14
In the good news case, in response to an anticipated fiscal expansion, both ps ˙ 0 and q˙ s 0 loci shift downwards, but q˙ s 0 shifts by more than ps ˙ 0, which can be easily inferred from footnote 10 with D - 0 and Da qg - 0. Under such a situation, similar to panels a and b of Fig. 3, two cases may happen too. Panel a of Fig. 4 depicts the situation where the LL line is flatter than the stable branch SS, while panel b of Fig. 4 describes the situation where the LL line is steeper than SS. 15 This suggestion was proposed by an anonymous referee, to whom we are grateful. 16 Combining the uncertainty of future political outcomes with the analyses of panels a and b of Fig. 4 will lead to dissimilar results from the Van der Ploeg Ž1989. analysis.
Diagram
Van der Ploeg’s Ž1989. result
Literature comparison
q first decreases then increases, q decreases, p increases Fig. 4, panel a opposite to Van der Ploeg Ž1989. p increases and Blanchard Ž1981. q first increases then decreases, q decreases, p increases Fig. 4, panel b opposite to Van der Ploeg Ž1989. p decreases and Blanchard Ž1981.
LL is steeper than SS q falls
q decreases, p increases Fig. 3, panel b Van der Ploeg’s Ž1989. result
q decreases, p increases Fig. 3, panel a opposite to Van der Ploeg Ž1989. and Blanchard Ž1981.
q decreases, p increases Fig. 2
After fiscal expansion
q rises
Good news Da qg - 0 D - 0 LL is flatter than SS
q decreases, p decreases
LL is steeper than SS q falls
q decreases, p decreases
q increases, p increases
q falls
Impact Before fiscal expansion response
q rises
D - 0 LL is flatter than SS
Bad news Da qg ) 0 D) 0
Cases
Table 1 Alternative adjustment patterns of anticipated fiscal expansion
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0q, an anticipated election of the Labour party causes the stockmarket value to rise from q0 to q0q so as to cause the economy to jump from the point E 0 to E 0q on impact. During the period from the run-up to the election eve, both q and p continue to increase, and the economy moves from E 0q to E e. On the morning after the election, the news of the election outcome will cause a discontinuous jump in the stockmarket value. 17 If the Conservative party is re-elected, the stockmarket value at once falls and the economy jumps from E e to E C on the stable arm SS C . Thereafter, the stockmarket value rises and the domestic price falls as the economy moves along SS C towards its long-run equilibrium E 0 . However, if the Labour party is elected to office and a fiscal expansion is enacted, the stockmarket value immediately rises and the economy jumps from E e to E L on the stable arm SS L . Thereafter, the stockmarket value turns to fall and the domestic price continues to rise as the economy moves along SS L towards its new steady state E ) .
5. Concluding remarks Based on the Van der Ploeg Ž1989. model, this paper has analyzed the evolutional behavior of the stockmarket value and domestic prices following an anticipated fiscal expansion. Two central conclusions emerge from the analysis. First, a fiscal expansion may lead to a boom in the stockmarket on impact even though the economy is operating in the situation of bad news, and may result in a crash in the stockmarket on impact in the context of good news case. Second, the adjustment pattern of the stockmarket value in response to an anticipated fiscal expansion may be misadjusting, even if the system exhibits saddlepoint stability rather than the global instability as proposed by Aoki Ž1985..
Acknowledgements The authors are grateful to the editor of this journal, Heinrich W. Ursprung, and two anonymous referees for their stimulating suggestions and helpful comments on an earlier version of the paper. We alone are responsible for all the views and remaining errors herein.
17
Ž1986, p. 158. offers an excellent interpretation of a scheduled election as an announced Gartner ¨ policy change, and of an election result as a surprise policy change.
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