Stock Market Cycles and Supply Side Dynamics

61 Pages Posted: 3 Oct 2015

See all articles by Paul De Grauwe

Paul De Grauwe

CESifo (Center for Economic Studies and Ifo Institute for Economic Research); London School of Economics & Political Science (LSE); Centre for Economic Policy Research (CEPR)

Eddie Gerba

Banco de España; London School of Economics & Political Science (LSE); CES Ifo Institute; European Central Bank

Date Written: June 18, 2015

Abstract

The agent-based (behavioural) model is extended to include a financial friction on the supply side. Firms finance capital purchases using external financing, but need to pay for it in advance. In addition, firm financing constraint and net worth are determined by stock market prices, which can (and will) deviate from the fundamental value. The result is that production, supply of credit and the share that firms pay to capital producers heavily depends on the stock market cycles. During phases of optimism, credit is abundant, access to production capital is easy, the cash-in-advance constraint is lax, the risks are undervalued, and production is booming. But upon reversal in market sentiment, the contraction in all these parameters is deeper and asymmetric. This is even more evident in the behavioural model since cognitive limitations of economic agents result in exacerbation of the contraction. Lastly, the behavioural model matches much of the data, including the interest rate, inflation, firm credit, firm financing spread, and bank net worth. It is also successful in matching several supply-side relations (capital-firm credit, inflation-interest rate) as well as their autocorrelations. The results from the empirical validation are favourable to the behavioural model.

Keywords: Supply-side, beliefs, financial frictions, model validation

JEL Classification: B41, C63, C68, E22, E23, E37

Suggested Citation

De Grauwe, Paul and De Grauwe, Paul and Gerba, Eddie, Stock Market Cycles and Supply Side Dynamics (June 18, 2015). Available at SSRN: https://ssrn.com/abstract=2668690 or http://dx.doi.org/10.2139/ssrn.2668690

Paul De Grauwe

London School of Economics & Political Science (LSE) ( email )

Houghton Street
London, WC2A 2AE
United Kingdom

CESifo (Center for Economic Studies and Ifo Institute for Economic Research)

Poschinger Str. 5
Munich, DE-81679
Germany

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Eddie Gerba (Contact Author)

Banco de España ( email )

Alcala 50
Madrid 28014
Spain
(+34)917088132 (Phone)

London School of Economics & Political Science (LSE) ( email )

Houghton Street
London WC2A 2AE
United Kingdom

CES Ifo Institute ( email )

Poschinger Str. 5
Munich, 01069
Germany

European Central Bank ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

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