Financial Markets and the Macroeconomy

Abstract

The objective of this paper is to provide a deeper insight into the links between financial markets and the real economy. To that end, we study the short-term anticipation and response of U.S. stock, Treasury, and corporate bond markets to the first release of U.S. macroeconomic information. Specifically, we focus on the impact of these announcements not only on the level, but also on the volatility and comovement of those assets' returns. For that purpose, we estimate several extensions of the parsimonious amended GARCH model of Engle (2002) for the excess holding-period returns on seven portfolios of these asset classes. We find that the process of price formation in the U.S. financial markets appears to be driven by fundamentals; yet, "excessive" volatility and comovement play an important role in return dynamics as well. Further, our analysis reveals a statistically and economically significant dichotomy between the reaction of the stock and bond markets to the arrival of unexpected fundamental information. However, we also show that stock and bond returns tend to react to the expected component of these announcements. Overall, the above results often differ from earlier studies where the surprise portion of those releases was not identified, and shed new light on the mechanisms by which information is incorporated into prices.JEL classification: C32; G14

Asset Markets, Portfolio Choice and Macroeconomic Activity

“…This figure shows the level of the exchange rate s o at the intersection of the domestic demand curve for foreign bonds (the supply curve for domestic bonds) and the foreign demand curve for domestic bonds (the supply curve for foreign bonds) and where therefore capital flow equilibrium is established. The equilibrium exchange rate depends on foreign characteristics, in contrast to the case considered in Chiarella, Flaschel, Franke and Semmler (2009) where domestic bonds are considered as non-traded goods and where therefore the supply of such bonds (in the case of a flexible exchange rate regime) is simply given by the bonds held domestically, F p . In this case the equilibrium in the domestic market for foreign bonds would be determined by the intersection of the f d curve with the straight line shown in the above figure and would thus be independent from foreign asset demands, definitely a situation that is too simple to characterize today's international financial system.…”

“…The jump variable technique of the rational expectations school therefore simply excludes the possibility of an unstable economy by assumption. The reader is referred to Chiarella, Flaschel, Franke and Semmler (2009) for detailed evaluations of this methodology, its attractiveness and its various anomalies:…”

“…7. We note that the comparative statics is easier here than in the stock approach of Chiarella, Flaschel, Franke and Semmler (2009), since more partial in nature and since the real exchange rate does not matter here, due to our assumption that foreign real demand on the international capital markets is expressed in terms of the domestic commodity and not in terms of the foreign one. We leave again the discussion of this latter case for future reconsiderations of the MFT model with international capital markets.…”

“…It needs reformulation for xi xii Preface open economies, since capital accounts are to be represented in terms of flows. To achieve this we build on the Mundell-Fleming-Tobin (MFT) portfolio approach of Chiarella, Flaschel, Franke and Semmler (2009) which simplifies the real side of the KMGT macroeconomy considerably, in order to focus on the analysis of stock-flow interactions for small open economies as well as for interacting two-country macrodynamics.…”

Effects of Inflation Expectations on Macroeconomic Dynamics: Extrapolative Versus Regressive Expectations

“…We hope that the present paper adds to this interesting and relevant stream of literature. From a broader point of view, our work is directly related to the theory of nonlinear macroeconomic dynamics as developed and surveyed by, among others, Day (1999), Rosser (2000), Puu and Sushko (2006) and Chiarella et al (2005Chiarella et al ( , 2009). …”