Total Social Finance: Mutual Influences between Financial Markets and Macro Economy

Abstract

It was not until the outbreak of the global financial crisis in 2007 when people turned to Hyman Minsky's financial-instability hypothesis. Owing to the critique that financial markets are not taken into consideration in economic analyses, recent macroeconomic literature has started incorporating financial sectors in the models. This paper addresses this issue in a way that we extend a macroeconomic model to incorporate a standard agent-based model from the finance literature, aiming to investigate how the financial market and the real economy interact with each other. The boundedly rational investors derive the fundamental value of financial market by looking at the macroeconomic variables. Meanwhile, the financial market influences the price level through the wealth effect. Empirical investigation using US data shows that short-term interest rate decreases in corporate profit rate and increases in debt ratio, supporting the Minsky hypothesis and the financial accelerator mechanism respectively. We also find evidence of the mutual influence between the macroeconomic variables and the stock market. Moreover, our results provide some justification to the recent policy measure of the central bank of China -- total social finance which includes financial markets in measuring money supply.