Fundamental share prices and aggregate real output

Abstract

This study analyses the interrelationships between the share market and the macroeconomy within the framework of a structural vector autoregressive (SVAR) model. The model has just two variables – real share prices and real output – and uses a distinction between temporary and permanent shocks to identify macroeconomic and share market-shocks. The identification of the SVAR is based on a simple theoretical model of the two-way linkage between output and share prices. In one direction a version of the net-present-value model is used and in the other direction the wealth effect is relied on as the basis for the influence of share prices on output. The estimated model is used to examine the dynamic interaction between the two variables. The study goes on to use it to compute a fundamental share-price series based on the assumption that fundamentals are driven by real macroeconomic forces.