Macroeconomics and finance: The role of the stock market

Camegi~Rochestw Conference .98&s on Public Policy 21 (1984) 109 116 North-Holland

MACROECONOMICS AND FINANCE:

THE ROLE

OF THE STOCK MARKET A Cement

on the

Fischer/Merton

Bennett

T. McCallum*

Carnegie-Mellon

Paper

University

and National

The main

theme

of the paper

that macroeconomists the

following

effect

and express

in support

should

paragraphs

In their

While

issue with conditional itself,

of

conclusion

course,

policy

advisor,

ditional

forecasting,

issues

*I

not

is.

that

stock

important

their

arguments

by

to

the

reason

is In

to

that

separate

Science

price

indices and

I am not inclined

That

an economic

structural

interested

un-

is

in

scientist

relations in the

in-

to take

in making

variables.

or

and

stock

con-

market.

to it later in the paper. comparison

specialists,

in

the

capital

discussion

explanatory

for

with

evidence

consumption,

can be useful

an instructive

finance

National

GNP,

prices

intensely

concerning

This

in stock market

for

macroeconomic

concerned

F&M provide

decisions.

‘That

F&M)

bits of statistical

could be raised,*

become

studies

am indebted

content

that point and return

upon

in

several

a sufficient

to

III,

focussed

vestment

of

necessarily

But F&M recognize

economists,

(hereafter,

to the stock market.

review

that movements

predictive

forecasts

In Section

and Merton

attention

briefly

II, F&M present

a few quibbles

their

more

I will

of the proposition

vestment.

by Fischer

devote

a few reservations.

Section

incremental I

have

of Economic Research

Bureau

cost

could

Foundation

of

contrast

be usefully

(SES 82-08151)

power

in

are

not

included

2

and

3).

that

regressions

of the different with

relevant consulted,

for

financial

include

macrofor

in-

I would

support.

other

predictor

variables. %oney the

explanatory and

supply

regressions

Sims

power (1983)

changes, conducted for

that

0 167-2231/84/$03.00

real is

for by

example, F&M

(Tables

GNP provided

reported

in

F&M’s

by Ml Table

innovations

among

The in

the

reason, the

explanatory presumably,

VAR study

1.

@ 1984 Elsevier Science PublishersB.V. (North-Holland)

variables is

by Cuan,

the

in Small

Litterman,

think, by a specialist ship to the other. of investment

behavior

for equities criticize rate. of

in either

should

in comparison

the tendency interest

field seeking

In Section

give

relatively

with the market

ignoring

more attention

analyses

to the market

In particular,

discussions

equity

its relation-

that macroeconomic

for bonds.

for policy-oriented

on bonds,

to learn about

IV, they argue

they

to focus on the real

yields.

Their

points

in this

regard seem to be well-taken. In

Sections

V

controversial. that

more

They

movements

cause

fundamental

begin

Their

by

stock

fluctuations. gyrations and

conforming

more

than

some reason

to believe, sense caused

tentatively, that

smoothing they

out

therefore

in aggregate

the

3 pr,ce

started

tterr

I

path

includes

lettovrr

am

item.

using

cc2mpO"e"t

terms

the

JII i5

movements

JS

I”

not

af-

source

of

to stock waves

movements

somewhat

of not

(1981)

do in fact fluctuate

fundamentals.

that investment

that case

There

and other aggregates

In addition,

the previous for having

and still

conclusion

the monetary

in equities

is then

in turn authority

with the objective

form of activism volatility

could in

of

in principle,

stock

prices

and

and GNP. argument,

With respect

by Shiller

two

be

(1981) and LeRoy and Porter

excessive

investment

of

will

the

"bubbles,"

that stock prices

This

consists

"irrational

and

more

predictive

tenta-

operations

reduce

price

of

more

by market

to this multipart

first

line of work

to

by

by stock price movements.

movements.

serve

In response with

price

they conclude,

stock

(i.e.,

whatever

theme stock

is

managers

more

the

rates will respond

Second,

of Shiller

open-market

price

argue,

to

that

manner,

rational

is, by stock

there may be a valid

suggest,

they

F&M go on to hint

(the Fed) conduct

of

is

of their

whether

sense

in a guarded

about

is warranted

of

some

brought

for the notion

that

strand

Granger-causality

fundamentals."3

the studies

issue

investment

are

material

to one

in

decisions

if these

are in this

suggests

forth

In particular,

support

violently

more

put

to

macroeconomists

the

of

fluctuations,

"market

F&M cite

as providing

to

that

pessimism"--that

to

by

fluctuations

investment

even

turn

relevant

given

returning

than

price

these

tively,

by

answer,

the

price

optimism

authors

be

investment

First,

fected

the

should

importance

content).

VI,

It is, furthermore,

emphasis

market.

parts.

and

I see little reason

to the second,

and LeRoy/Porter4

Flood

and Garber

resulting

from

explosive.

110

(1980). market

to quarrel

I would agree that the should

Thus

be given

the bubble

tundamentals,

serious

component

whether

or

not

oi

3

thtB

consideration the

but

excessive One

clusive.

I would emphasize,

volatility rather

that the underlying Nelson this

even

evidence

important

series

and Plosser

(1982).

nonstationarity

may

more

collected

reason

than to

do

date

for doubt

variance-bounds

con-

far

from

the

possibility

in the terminology

If this is the case, failure tests

of

to take account

to

incorrectly

reject

with very

more,

be kept in mind that in tests of this type it is especially

important

for

included risk

the

investigator

in market

preference

changes

are

or

are appropriately

There ties

ideal,

the

if

in

authors

But

signed

that

are

properly

I would add, are changes

individuals'

tastes. study's

fundamentals,

in

While

such

residuals,

they

not as a hypothe-

this

usually

prices

actual

issue

only

level,

bubble

intervention to

phenomena

that

bubbles

of

stock

bubble

at that

to counteract

will

variables

an empirical

of whether

induce

fact

recognize

even

possibility

lutions

of

into

the question

I will discuss

volved.

aspects

as part of market

systematically

the

omit these,

Further-

component.

fundamentals, Since

to

Among

thrown

viewed

remains

can

other

necessarily

sized bubble

not

fundamentals.

even in large samples.5

of

null hypotheses it should

high frequency,

that

involves

are not trend-stationary,

lead

the authors, is

conform

are

of

policy

at the

will

level

be effective.

be available

more

empirical

behavior

it is not clear

solutions

by policy

may

be

policy

The problem an

and open-market

closely

to

importance. less

than

of the principles

that

is admitted,

authori-

de-

is this:

infinity

policy

in-

actions

of

cannot

once

such

so-

determine

which of these will obtain. An example following

may help to describe

supply and demand

the issue.

functions,

Consider

displayed

a market

with

the

Grossman

and

in that order:6

Yt = "1Pt + ut

4

Subsequent

Shiller

(l981), 5

dlso

Thas

made

studies Hansen

tendency by

Marsh

Flav~n

(1983)

highly

autoregressive,

discussion of

stated

will

IS

derives

Constant

interest

S8ngleton

Merton

have (1982).

illustrated

and

in (1983)

results

series.

Flavin’s

provide

!ncorrr~t levels.

paramrrer

+o 1.0.

terms

suppressed

are

in for

conducted

finite

for

reported

samples also rxce~s

is

more

notational

111

by by in

indicate volatility dramatic,

simplicity.

Flavin

and

revnew

ot

tendency

by

(1980).

a recent

results

indications The

been

Singleton

simulations dnd

dnalyt~cal

significance

3utoregrassive 6

of and

(19831,

others.

Kleidon LeRoy cases that

(1983). (1984). involving tests

with presumably,

The

poinf

Earlier

work

stationary, of

the

type

frequencies the

in closer

is by but

under excess IS

the

Yt = B~P~ + 62Etpt+l. Here a1

> 0,

13~ < 0,

and 62 > 0 while ut is white

assumed

that

current

price

taining

to the expected

bubble-free

solution,

effects

future

on demand

price:

noise.

)611 > 62.

the one that involves

It is furthermore

are stronger Now

than

those

in this market

no extraneous

perthe

state variables,7

is easily found to be

al)-l

pt = (61 -

(3)

Ut.

But suppose that we consider

solutions

of the Form

Pt = n1ut + '"2Pt_1 + "3Ut_1' Then

Etpt+l

latter

= n2(mlut

plus

cerning

(2) and

+ ~~~~~~ (4)

into

+

n3ut_T)

+ r3ut

(1) yields

the

and

substitution

following

of

implications

the con-

the S'S:

(aI - 61)x1 + 1 = 62"1'2 + 62'3

(54

61)112 = 62~$

(01 -

(5b)

(01 - 61)n3 = 62~2x3 From

the

second

solution)

Or

(5a) yields

~2

Presumably an

7

That

8% argued

(a1

-

it is seen

that

“1Ut + (a1

IF the latter

61)/62.

n2 = 0

(the bubble-Free

is deemed

undetermined.

relevant,

then

That is,

-1

-1

-

either

(6)

q32 pt_1 + 62 Ut-1

value of nl.

How would

Thus

=

these

r3 = l/62 but r1 is completely

pt = for any

of

activist

by making

activist

the dt

existence length

in

open-market

government

policy

of

15 precluded

(1983).

112

be represented

dependent

is represented

bubbles

McCallum

policy

demand

by

in

the

upon

a nonzero

3bsence

of

in this

the value

extraneous

current for

state

system? price.

~1 in the

variables

demand

function

where

vpt

is government

possible

values

fore,

is entirely

with

x1

market

re-starts

the dynamic

In

So

fundamentals. simply

a

occur

this

and

So changing

free.

government.

mentals,

with

for n2 in (4) are zero

u f 0, which

the

Then

demand.

value for '~1 and consequently by

(2’ 1

upts

yt = 61pt + 62Etpt+l +

a regime

system,

But,

with

government

bubbles,

i.e.,

demand

as be-

in a different

from that planned

constitutes

departures

to a different

the

P = 0 to one

could result

of pt different

sense,

relative

in the model,

(al - a1 - u)e2.

from

in behavior

change

from

part

market

point

of departure

in this example

to eliminate

of

funda-

when

u *

0.8 It is true that u can be chosen regressive for

of pt: setting

n2, as well

determine ables. 01

part

+

as the first,

n1 if we are considering

al -

There

ly, quite

of course,

are,

the solution

it is unclear

bubbles vation

value

not serve

with extraneous

fluctuations

concerning somewhat

from

concerning

the

The the

the

serving stock

open-market those

rational

to

state vari-

But

market

as well

argument

it does

and

This

of

is my main if

not, even

reser-

accepted,

as the relationship

of many

between

to

of the

if accepted,

review

in

speculative

for the importance

instructive

why

can be successful

result

It tends,

paper.

of their

as a useful

the

is, admitted-

serve to indicate

policy

are

not represented

discussion

expectations.

Fischer/Merton

the strength

activism

may nevertheless

when

in macroeconomics.

the paper

financial

with

of policy

bubble-component

But the example

in an economy

stock market

forms

to me that activist

price

diminish

other

And the entire

nebulous.

dampening

8

But that does

to zero.

the auto-

possible

By.

by this example.

in

equal

the second

And the minimal-state-variable, bubble-free solution is pt = (aI -1 U) ut, so the variance of pt in this solution becomes large as u

approaches

I.0

u = 01 - 61 makes

keep topics

macro

and

economics.

line model

of

argument at

developed

by

Peel

(1981)

hand.

113

is

not

dwlicable

because

I(a,

-

6,)/62/

>

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