The equity price channel in a New-Keynesian DSGE model with financial frictions and banking

Stellenbosch Working Paper Series No. WP16/2013 (revised, version: 2)
 
Publication date: 2013
 
Author(s):
[protected email address] (Department of Economics, University of Stellenbosch)
[protected email address] (Department of Economics, University of Stellenbosch)
 
Abstract:

This paper studies the role of the equity price channel in business cycle fluctuations, and highlights the equity price channel as a different aspect to general equilibrium models with financial frictions and, as a result, emphasizes the systemic influence of financial markets on the real economy. We develop a canonical New-Keynesian DSGE model with a tractable role for the equity market in banking, entrepreneur and household economic activities. The model is estimated with Bayesian techniques using U.S. data over the sample period 1982Q01 - 2012Q01. We show that a New Keynesian DSGE model with an equity price channel well mimics the U.S. business cycle. The model reproduces the strong procyclicality of the equity market. The equity price channel significantly exacerbates business cycle fluctuations through both financial accelerator and bank capital channels. Our results support the increasing emphasis on common equity capital in Basel III regulations. This is beneficial in terms of financial stability, but amplifies and propagates shocks to the real economy.

 
JEL Classification:

E32, E43, E44, E51, G12

Keywords:

Equity price channel, asset pricing, financial frictions, bank capital, New-Keynesian, Bayesian

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BER Weekly

14 October 2019
While incoming data on the global economy remains downbeat, the mood was lifted last week after progress was made on US-China trade talks and Brexit negotiations. On the domestic data front, mining and manufacturing data for August added to growing evidence that real GDP growth likely slowed significantly in 2019Q3 after the nice rebound recorded in...

Read the full issue