Abstract
We reformulate and extend the Blanchard model of output dynamics, the stock market and interest rates that incorporates equities and bonds into traditional Keynesian IS–LM analysis. As investment demand now depends on Tobin's average q in the place of the real rate of interest, the share price dynamics feedback into the real sector. Our model allows imperfect asset substitutability, and contains boundedly rational heterogenous agents who make imperfect forecasts of capital gains and whose expectations are state-of-the market dependent. These elements introduce an underlying nonlinear dynamic feedback mechanism between the real and financial sectors that allows for bursts of optimism and pessimism. Furthermore, we introduce some stochastic elements into the model and use numerical simulations to study the interaction of the nonlinear and stochastic elements, focusing in particular on the propensity of the model to generate stock market booms and crashes.
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