The interaction between asset prices, credit and the macroeconomy

The thesis investigates the interaction between asset prices and the real economy. While many features of the interaction between asset prices and the real economy are successfully explained by the neoclassical models, there are also some phenomena that have long puzzled economists. In this thesis, three aspects of the interaction between asset prices and the real economy are explored in four essays. The first essay examines the long-run relationship between stock returns and economic growth. Based on a general equilibrium stochastic model, it is established that the relationship between stock returns and economic growth is ambiguous due to output volatility. Using panel data over more than a century for the 20 industrialized countries, the results show an absence of any positive relationship between stock returns and growth except for the period 1920-1950 during which output growth was dominated by severe output fluctuations. The second essay explores monetary transmission through the lending channel. By introducing credit constraints to the optimization problem of the household sector, the model predicts that credit is an important determinant for consumption of both durables and nondurables. Using survey evidence of banks’ willingness to lend (WTL) as a measure of credit availability, the results show that consumption is driven predominantly by WTL. Monetary policies, after 1985, have lost their grip on consumption. However, consumption has been increasingly and predominantly driven by asset prices through WTL. The third essay attempts to disentangle the channel whereby asset prices influence non-durable and durable consumption. Following the expressions derived in the second essay and based on banks’ WTL, the results show that the conventional wealth effects of house prices and stock prices vanish when WTL is included. This implies that assets prices affect consumption through banks’ WTL and not through the traditional wealth effect channel. The last essay examines the relationship between housing returns and consumption growth. Based on the data for 18 OECD countries over the period 1970 to 2009, it shows that, given a plausible level of risk aversion, the combination of a high excess return and low covariance of its returns with consumption is difficult to justify accounting for risk alone. That is, there is a “Housing Premium Puzzle”. Both theoretical analysis and empirical results show that transaction costs and borrowing constraints may be potential explanations of this puzzle.