Research Database

There is widespread agreement that a surprise increase in an economy's money supply drives the nominal interest rate down and economic activity up, at least in the short run. This is understood as reflecting the dominance of the liquidity effect of a money shock over an opposing force, the anticipated inflation effect. This paper illustrates why standard general equilibrium models have trouble replicating the dominant liquidity effect. It also studies several factors which have the potential to improve the performance of these models.

Stochastic inflation affects the risk characteristics, measured by the equity premium and the correlation of the equity’s return with consumption, in a fundamental way. The riskiness of a dollar-denominated asset depends on two conditional covariances: the covariance of the marginal rate of substitution (MRS) with the equity price and the covariance of the MRS with the rate of appreciation in the purchasing power of money. The second covariance may take either sign which becomes significant when the risk characteristics of the dollar-denominated asset are compared with the risk characteristics of an indexed asset constructed in a real version of the model.

The effects of stochastic inflation on the assets’ risk characteristics are studied in a parameterized version of a cash-in-advance asset-pricing model. The growth rates of the endowment and monetary transfer evolve according to a VAR. The equity price is a geometric distributed lead of log–normally distributed random variables; an algorithm to express the price as an explicit function of the state variables is described.

Barksy-Miron [1989] find that the postwar U.S. economy exhibits a regular seasonal cycle, as well as the business cycle phenomenon. Are these findings consistent with current equilibrium business cycle theories as surveyed by Prescott [1986]? We consider a dynamic, stochastic equilibrium business cycle model which includes deterministic seasonals and nontime-separable preferences. We show how to compute a perfect foresight seasonal equilibrium path for this economy. An approximation to the stochastic equilibrium is calculated. Using postwar U.S. data, GMM estimates of the structural parameters are employed in the perfect foresight and simulation analyses. As in Constantinides and Ferson [1990], the estimates of consumption preferences exhibit habit-persistence, but a local optimum also exists which exhibits local durability.

The nontime-separable model predicts most of the seasonal patterns found in aggregate quantity time series; notable exceptions are the seasonal patterns in investment and the fourth quarter seasonal in labor hours. An evaluation of the model’s predictions for deseasonalized second moments finds strong support for the parameterization with local durability in consumption. This model broadly displays a seasonal cycle as well as the business cycle phenomenon.