A Capital Market In an Equilibrium Business Cycle Model

Abstract

Previous equilibrium models are extended by the incorporation of an economy-wide capital market. This extension alters the information structure of these models and modifies the relative price variable that transmits money shocks to real variables. Monetary effects on nominal and real interest rates are a focus of the analysis. THIS PAPER exends previous equilibrium business cycle models of Lucas [10, 11] and myself [4] by incorporating an economy-wide capital market. One aspect of this extension is that the relative price that appears in the supply and demand functions in local commodity markets becomes an anticipated real rate of return on earning assets, rather than a ratio of actual to expected prices. The analysis brings in as a central feature a portfolio balance schedule in the form of an aggregate money demand function. The distinction between the nominal and real rates of return is an important element in the model. From the standpoint of expectation formation, the key aspect of the extended model is that observation of the economy-wide nominal rate of return conveys current global information to individuals. In this respect the present analysis is distinguished from Lucas' [12] model, which considered only local (internal) finance. However, my analysis does not deal with the dynamics of capital accumulation, as considered by Lucas, and does not incorporate any other elements, such as inventory holdings, multi-period lags in the acquisition of information, or the adjustment costs for changing employment that were treated by Sargent [16], that could produce persisting effects of monetary and other disturbances. In order to retain the real effects of monetary surprises in the model, it is necessary that the observation of the current nominal rate of return, together with an observation of a current local commodity price, not convey full information about contemporaneous disturbances. Limitation of current information is achieved in the present framework by introducing a contemporaneously unobserved disturbance to the aggregate money demand function, along with an aggregate money supply shock and an array of disturbances to local excess commodity demands. Aggregate shocks to the commodity market (to the extent that they were not directly and immediately observable) could serve a similar purpose. With respect to the effect of money supply shocks on output, the model yields results that are similar to those generated in earlier models. Notably, incomplete