Empirical and Theoretical Linkages Between the Real and Financial Economy

New York University, New York NY

Investigators

Abstract

The project aims to build understanding of the empirical and theoretical links between the real economy and asset markets. The project considers a number of specific questions related to the aggregate consumption-wealth link, and focuses on the importance of macroeconomic indicators for separating permanent from transitory movements in stock prices and for documenting the extent to which the conditional mean of stock returns is related to its conditional volatility. The research also investigates ways in which key asset pricing facts can be reconciled with a complete business cycle model that preserves the realism of the model's implications for real variables. The methodology is both empirical and theoretical. The empirical methodology relies primarily on unit root econometric techniques to identify the short-run and long-run relations between various measures of real activity and asset markets, using U.S. aggregate time-series data. The theoretical methodology builds off of recent insights in both finance and macroeconomics to study a dynamic, general equilibrium model of the economy. Understanding how consumption is related to wealth is fundamental for the informed conduct of monetary policy and macroeconomic analysis generally, and for modeling, theoretically, how the real and financial sectors of the economy are related. As yet, however, there has been little formal empirical analysis of these relations. Moreover, we cannot hope to understand the volatility and predictability of asset returns without understanding the sources of macroeconomic risk that underlie this behavior. The empirical and theoretical investigations of this research agenda have the potential not only to help expand the state of knowledge about how consumption, production, investment and asset prices must be related theoretically, but also to facilitate the search for macroeconomic determinants of systematic risk factors that must ultimately govern the behavior of asset prices.