Effects of anticipated central bank actions on Tobin's Q, share prices and exchange rate in a small open economy

Abstract

Qualitative features of response patterns of domestic share price, the exchange rate and Tobin's Q are analyzed to compare the effects of three types of anticipated central bank policies in a small open economy: exchange of domestic money with domestic shares; exchange of domestic money with foreign bonds; and exchange of domestic shares with foreign bonds, all of equal values in domestic currency. Tobin's Q adjusts monotonically to a new equilibrium in response to all three anticipated actions, aside from the initial discontinuous changes when anticipated actions are first announced. Under a set of plausible assumptions on the model parameters, the exchange rate and the share price are shown to respond non-monotonically to the announced exchange of domestic money with foreign bonds, if the announcement is made sufficiently far in advance. The paper also demonstrates that the exchange of domestic shares with foreign bonds is most effective in moving the terms of trade. The paper establishes conditions for nonmonotone response patterns in terms of real rate of return to the domestic shares, after distinguishing overshooting response pattern from another non-monotone pattern, called misadjusting in this paper, where the initial response of a variable to a shock is a movement away from equilibrium. These response patterns are characterized in terms of two parameters and their relative sizes with respect to the implementation lags of announced actions.