NoteMarkets - Lecture Note on Money/Macro and Financial...

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1 Lecture Note on Money/Macro and Financial Markets Econ 135 - Prof. Bohn This note examinew how macroeconomic news affect stock and bond markets. In particular, we will study why good news about the economy is sometimes bad news for the stock market, and conversely. Section 1 develops the link between macroeconomic theory and stock and bond prices. Section 2 shows how shifts in the IS, LM, and aggregate supply curves affect the stock and bond markets under different conditions. Section 3 examines the implications for monetary policy. 1. Stocks, Bonds, and Macroeconomics To start, recall some important facts about stocks and bond markets: 1. Financial markets are efficient. That is, new information ("news") is quickly reflected in stock and bond prices. Economic changes will affect asset prices when the news comes out and not when the changes actually take place. The starting point for our macroeconomic analysis is therefore the position in which the economy is expected to be at various times in the future; this may differ from the current position. In the output-interest rate diagram below, the relevant expected levels of output and the interest rate are labeled Y 0 and i 0 (say, representing projections for next year). 2. Output growth is generally positive for profits and dividends. Hence, stock prices typically increase when output rises unexpectedly (relative to Y 0 ). 3. A higher interest rate tends to reduce asset prices because future payoffs are discounted at a higher rate. Both stock and bonds prices typically fall when interest rates rise (relative to i 0 ). For any given increase in interest rates there will be a critical value of how much output has to increase to prevent a change in stock prices. The set of output and interest rate combinations that leave stock prices unchanged can be drawn into the diagram as a positively sloped line. Stock prices stay constant along this line. Starting at point (Y 0 ,i 0 ), stock prices rise (fall) if the economy moves below (above) the line. Bonds Stocks up i Y i 0 Y 0 Ps Pb Ps Pb Ps Pb Ps Pb
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2 In summary, we can divide the space of interest rate-output combinations into areas of rising and falling stock and regions of rising and falling bond prices. These areas tell us how stock and bond prices are likely to respond if there is economic news that alter expections about future output and interest rates. Now we can apply macroeconomics and draw IS, LM, and aggregate supply curves into the same diagram, using the same starting point (Y 0 ,i 0 ). Using expected values as starting point is a bit unusual for macroeconomics (actually: an innovation of this lecture note) because macroeconomists usually draw curves reflecting the current or historical status of the economy. In an efficient markets context, however, economic changes that are anticipated will not move markets; macroeconomic changes matter only if they differ from expectations. It’s more instructive therefore to draw curves in a forward
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This note was uploaded on 12/26/2011 for the course ECON 135 taught by Professor Bohn,h during the Fall '08 term at UCSB.

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NoteMarkets - Lecture Note on Money/Macro and Financial...

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