Journaf of International Money and Finance (1989).

8, 18 I-200

The stock market and exchange rate dynamics

MICHAEL GAVIK*

Columbia University, New York, NY 10027, USA

This paper articulates a model of the open economy in which, as in Tobin

(1978), the price of shares in the stock market substitutes for the real
interest rate in the determination of aggregate demand. The stock market
reduces the impact of monetary policy on the real exchange rate; indeed,
if the link between stock prices and aggregate demand is important
enough, the impact of monetary policy on the real exchange rate can be
reversed. In contrast with standard, dynamic Alundell-Fleming models,
anticipated fiscal policy can be expansionary rather than contractionary as
in, for example, Burgstaller (1983), Blanchard (1984), and Branson et al.
(1985).

It is often perceived that developments in national stock markets influence foreign

exchange markets, and, conversely, that outcomes in exchange markets can affect
stock markets. Of course, in any complete model exchange rates, interest rates, and
stock prices are endogenously determined and it makes little sense to ask how a
change in one asset price will affect another asset price; the correlation between
asset prices will depend upon what kind of disturbance generated the price
movement.
A question that can be answered is: how does the existence of a stock market
affect the response of capital flows, interest rates, and exchange rate dynamics to
shocks of one sort or another, compared with a more conventional model that
incorporates a bond market only? Similarly, how does the existence of capital
mobility and foreign trade alter the response of output, interest rates and stock
prices to exogenous shocks, compared with a closed-economy model that
incorporates a stock market? This paper addresses those questions by articulating a
model of the small, open economy in which the price of shares in the stock market,
rather than the real interest rate, determines domestic aggregate demand.1
The introduction of stock market effects into an otherwise conventional
macroeconomic model requires but little motivation. Movements in current and
expected future profitability, as well as interest rates, are widely understood to
affect investment and consumption, through both relative-price and wealth effects.
The stock market, broadly interpreted as all marketable claims on the future profits
of firms, forms the link between future profit and interest rate fluctuations, and

* I am especially indebted to Rudiger Dornbusch and Dale Henderson for encouragement and
many helpful comments. Helpful conversations with Olivier Blanchard and Stanley Fischer are also
gratefully acknowledged, as are the comments of an anonymous referee. Remaining errors are my
responsibility.

0261-5606/89/02/0181-2OSO3.00 Q 1989 Butterworth & Co (Publishers) Ltd

182 The stock market and exchange rate &amics

current investment and consumption decisions. * Omission of these effects would

be justified if they did not alter the model’s properties; however, I show below that
the open-economy stock-market model can exhibit output and asset-price dynamics
that differ significantly, and in an economically illuminating way, from more
conventional models.
The paper is organized as follows. In Section I the model is outlined, and its
general properties discussed. In Sections II and III the implications of the model are
further explored by using it to analyze the impact of changes in monetary and fiscal
policy, respectively. In particular, it is shown in Section II that the introduction of a
stock market tends to reduce the response of the real exchange rate to monetary
policy; indeed, if the stock-market linkages are strong enough, the relationship
between monetary policy and the real exchange rate can even be reversed. In
Section III it is shown that, under some circumstances, an anticipated future fiscal
expansion may not have the contractionary properties identified by Burgstaller
(1983) and Branson et al. (1985), and may instead be expansionary. Section IV
concludes.
The reader is forewarned that the following analysis becomes somewhat
tasonomic at times, with the results depending upon which of several cases is being
considered. It may be helpful to bear in mind that the existence of qualitatively
distinct cases stems primarily from two sources. First, as in Blanchard (1981), the
effect of an increase in aggregate demand on the value of the stock market is
uncertain, because higher demand and output leads both to high profits and, given
the real money supply, high interest rates. Consequently, it is necessary to
distinguish between cases in which an increase in output is ‘good’ for the stock
market, and others in which it is ‘bad.’ In addition, it is occasionally necessary to
distinguish between those cases in which the stock price or the real exchange rate is
more ‘influential’ in goods markets (in a sense that is defined more precisely below).

I. The Model

In order to facilitate comparison with the closed-economy case, the model builds
upon Blanchard’s 1981 analysis, differing in the assumption that the economy is
open on both current and capital account. Apart from the introduction of
stock-market effects on aggregate demand, the model is also in the spirit of the
dynamic, hlundell-Fleming analyses that are a familiar subset of the international
macroeconomics literature. Indeed, the model includes as a special case one version
of this ‘standard’ framework.
I examine an open economy that is specialized in the production of a single good.
The country is small in world asset markets, so that it has no influence on the world
interest rate, but it is large enough in goods markets so that demand conditions
within the country can affect the price of the home-produced good relative to the
imported good. The price level is assumed to be ‘sticky,’ and output is
demand-determined in the short run. However, prices are assumed to increase
(decrease) when aggregate demand is higher (lower) than the long-run equilibrium
level of output, so that in the long run output and employment converge to their
(exogenously-determined) full-employment level. There are four assets held by risk
neutral investors; money, domestic bonds, foreign bonds, and shares in the stock
market, the last of which are claims on the economy’s profits.
 MICHAEL G;\VIN 183

The Goods M&&t: Equation (1) relates the log of real aggregate demand for
domestically produced goods, d, to the real value of the stock market, q, the log of
real output,_y, a measure of fiscal policy, & and the log of the real exchange rate, 8,
where the real exchange rate is defined as the price of foreign-produced goods in
terms of home-produced goods:

(1) d= aq+@+yO+g.
The stock market affects aggregate demand through both wealth effects on
consumption, and because it determines the market valuation of capital relative to
replacement cost, thereby determining investment.3 Output influences aggregate
demand to the extent that workers are liquidity constrained, so that current income,
and not just the capitalized value of lifetime income, determines consumption. The
real exchange rate determines net exports through relative prices and, conceivably,
a wealth effect, the sign of which would depend upon the currency denomination of
assets held by domestic investors relative to the weight of foreign goods in the
consumption basket. Here I simply assume that a real exchange rate depreciation,
an increase in 8, raises aggregate demand.
Output is assumed to adjust gradually to the discrepancy between aggregate
demand and output.

(2) j = o(d-y) = a(aq-b_y+yl?+g),

where b = 1 - p, and a dot on top of a variable denotes a time derivative. Blanchard
(1981) offers two rationalizations for this formulation: that output might adjust
slowly to aggregate spending with the residual demand being satisfied with
inventory fluctuations, or that aggregate spending itself may adjust to the target
level, d, with a lag. In some instances below, I consider the special case in which 0 is
very large, so that output always equals aggregate demand.4
Although output is assumed to be demand-determined in the short run, prices
are assumed to adjust whenever output is not equal to its full-employment level.
Equation (3) gives the price adjustment equation, and equation (4) defines the
steady state price level:

(3) P= -%P-8
(4) p = m+ (Pcjyh.
Inflation is assumed to be inversely proportional to the deviation of the actual
price level from its steady-state level, and the steady-state price level is that which
secures money market equilibrium at the steady-state interest rate and level of
output.5 This formulation of inflation was chosen to permit comparison with
Blanchard (1981) and for analytical tractability. Alternative specifications, such as a
more standard Phillips curve or the contracting model of Calvo (1983), can be
explored in a simulation model.
./l.rset A~&~&ets: I adopt the standard liquidity preference formulation of money
demand, solved for the nominal interest rate, i. The money supply is exogenously
given by the monetary authorities:

(5) i = cy-&m-p),
(6) r = i-p.

Here p is the log of the price level, m is the log of the money supply, and r is the
184 The stock market and exchange rate dynamics

short-term, real interest rate in terms of home-produced goods.6 Investors are

endowed with perfect foresight, so there is no need to distinguish between expected
and actual price fluctuations.
The other asset-market equilibrium conditions are:

(7)
49 7
(8) r = r*+8,
(9) 7c = cc0 +a,_v.
Equation (7) requires that the expected real return on a share of the stock
market, which consists of both capital gains and profits II, equal the real return on
domestic bonds. Equation (8) is the open interest parity condition, where r* is the
foreign real interest rate. The world real interst rate, T*, is exogenously given and it
is the steady-state interest rate to which the small economy must converge.
Equation (9) introduces the assumption that real profits are an increasing function
of real output.
For future discussion, it is useful to note that equation (7) can be solved
forward, under the appropriate transversality condition, to obtain an expression for
the stock price as the present value of anticipated future profits, discounted at the
real interest rate:

- i 694
(‘a) q(t) = i?.c(+? ’ cls.

Similarly, (8) can be solved forward for the current value of the real exchange
rate as follows:
*
@a) e(t) = 8-J (r(s) - r*p
I

So the current real exchange rate equals the steady-state real exchange rate minus
a term that depends upon the cumulative, expected future real interest differential
between home-currency and foreign-currency denominated bonds. (7a) and (8a)
are of course partial equilibrium relationships; they are nonetheless useful for
expository purposes.
The parameter IX, determines the sensitivity of profits to output. Note that when
CI, is zero, the ‘stock’ looks exactly like an indexed perpetuity, so that the model
reduces to a standard open-economy IS-LM analysis, in which the interest rate that
affects aggregate demand is the real rate on an indexed consol. On the other hand,
when c(, is large, then profitability (and, in equilibrium, stock prices) will be very
sensitive to fluctuations in aggregate demand and output. Thus, CI, is a natural
measure of how different the present model is from those that have been analyzed in
the past. Consequently, it will be a key parameter in the analysis that follows.
TbeStean_VState: Steady-state output is by assumption exogenously given, and the
steady-state interest rate is the world interest rate, which is also exogenously given.
From (7), the steady-state stock price is the present value of steady-state profits,
discounted at the steady-state (foreign) rate of interest.
 MICHAEL GAVIN 185

The steady-state price level was defined in equation (4). Note that there is no
allowance in this simple framework for trend monetary growth and inflation;
extending the model to incorporate this possibility would be straightforward.
Finally, the steady-state real exchange rate is determined by imposing equilibrium
in the goods market. In steady state, output and aggregate demand must be equal to
the full-employment level of output. Imposing these equalities, and rearranging
(l), we obtain:

(11) 8= (b_++g)ly.

As in the static Mundell-Fleming model, a permanent fiscal expansion has no

effect on output, or the interest rate, it merely induces an exchange rate appreciation
sufficient to crowd out enough net exports to undo the expansionary impact of the
fiscal stimulus.’

=
Dynamics: Equation (12) is a linearized version of equations (1) to (9), which I
will use to examine the dynamic properties of the model in the neighborhood of the
steady state.

II
_ . .
-bo UC7 yo 0 Y-j
(c@--Lx,) r* 0 (b+6)q 4-4
t 0 0 (b+6) O-8
0 0 0 -6 p-P
_
In the technical appendix to this paper (available from the author upon request),
it is shown that, if

(13) a(@--cr,)+br*+cy > 0,

then (12) has a unique convergent solution. This condition is similar to, but
slightly weaker than, the one found in Blanchard (1981), which is, in turn, satisfied
if the IS curve cuts the LIM curve from above; I assume throughout that (13) is
satisfied. The two negative roots of the system determine the speed of adjustment
along the saddle path.8 One of them is - 6, the price-adjustment parameter, and the
other will be denoted -1.
Solution of the model requires only standard techniques, though it is
complicated and made tedious by the relatively high dimensionality of the system.
In this paper, I forgo a detailed discussion of technical issues; interested readers are
referred to the technical appendix or a longer version of this paper (Gavin, 1986),
both of which are available from the author upon request. The remainder of the
paper discusses the results of those analyses at a more intuitive level, focusing on the
impact of monetary and aggregate demand shocks.

II. Monetary Policy

Suppose that at time zero the economy is in steady state, and is disturbed by an
unanticipated increase in the money supply. The new steady state is identical to the
old, except that the price level is increased in proportion to the increase in the
money supply. The dynamic adjustment to the new steady state is somewhat more
interesting; the solution for prices, inflation, and output are shown in Figure 1.
The evolution of the price level is easy to determine, because of the simple price
186 The stock market and exchange rate &namirs

Price
level

lime
lnflatlon rate

lime

I Output

time

FIGURE 1. Response to a monetary disturbance

adjustment equation (3). The price level simply adjusts monotonically from its old
steady state to its new steady state regardless of output dynamics or, for that matter,
anything else. As the price level approaches the new steady state, the inflation rate
falls.
Output is ‘humpbacked,’ rising from the initial steady state, to a maximum at
time t, where

(14)
t* = log(W)
(6- 3,) ’
then falling asymptotically and monotonically toward the unchanged steady state.
This is not the truly cyclical behavior that would arise from a multiplieraccelerator
framework, or a more conventional Phillips curve equation; however, there is a
family resemblance. Note for future discussion that the larger is 1, the more quickly
output responds to the monetary expansion.
 MICHAEL GAVIN 187

The solution for the stock price dynamics can be briefly summarized. The stock
price jumps upward in the immediate aftermath of the monetary expansion, then
converges to its initial, long-run equilibrium. This transitory increase in stock
prices occurs for two reasons. First, the increase in output raises the profitability of
the national capital stock. Second, the real interest rate at which profits are
discounted in investors’ present-value calculations fall, at least in the short run.
Both effects tend to increase the equilibrium price of shares in the stock market.9
So far the model has exhibited no surprising properties. The exchange rate
dynamics, however, are somewhat more interesting. Note that, because both
output and the price level are ‘sticky’ in this model, the short-term real interest rate
necessarily falls below the foreign rate immediately after the increase in the money
supply, which implies that the rate of change of the real exchange rate at time zero is
negative; that is, expected real appreciation is required to equate anticipated returns
on home- and foreign-denominated bonds.
In simpler models, this anticipated real appreciation requires an initial jump
depreciation, and that is generally the case in this model as well. There is, however, a
second possibility, in which the monetary expansion leads to an initial jump
appreciation. I show in section A of the technical appendix that, if

( >
r* b+T -aC?,
then there exists some 6* such that if 6 (the price adjustment
< 0,

parameter) is less than

6*, the real exchange rate appreciates after a monetary expansion. This possibility is
illustrated in Figure 2C.
This counterintuitive possibility is clearly linked to the presence of the stock
market. In particular, it requires that aa, be large, where a is the impact of the stock
market on aggregate demand, and ~1, is the impact of output on profitability. In the
case in which profits are completely insensitive to fluctuations in output (the
‘indexed bond’ case, with c(, = 0), (15) could never hold, and thus expansionary
monetary policy would always lead to a transitory real depreciation.
The intuitive explanation for this apparently perverse ‘reverse overshooting’ is
as follows. In this scenario, the monetary expansion leads to a transitory decline in
the short real interest rate, because of both liquidity and inflation effects. Aggregate
demand and output increase, as a result of a large increase in the value of the stock
market. The increase in the stock price is large, and the resultant impact on

cur\ CasB

B. lb-
______________
IL d__ _____________________

FIGURE2. Possible paths for the real exchange rate after a monetary
expansion
188 The stock market and exchange rate +zamics

aggregate demand important, because a and ~1, are large. As output and the price
level increase, the demand for real balances increases while the supply declines,
requiring an equilibrating increase in the nominal interest rate. This, combined
with a gradually declining rate of inflation, generates a sharp increase in the short
real interest rate from its initial position below the world rate, to a level above the
world rate.
If this reversal of the interest differential is large, and occurs quickly enough,
then immediately after the monetary expansion the long-term real interest rate
actually rises, even though the short rate necessarily falls. As summarized in
equation (8a), with no change in the steady-state real exchange rate, this increase in
the long, real interest rate to a level above the foreign interest rate generates an
instantaneous exchange rate appreciation. Hence, if (15) holds and price
adjustment is slow enough, the rise in the long, real interest rate induced by an
expansionary monetary policy creates an exchange rate appreciation.
This ‘reverse overshooting’ scenario thus requires a rapid, large increase in
output which, because the real exchange rate has appreciated, requires an increase in
the stock market that is both large and effective in increasing aggregate demand. It
is easy to see how these requirements relate to condition (15).
I have already noted that a large c(, implies that output expansion will have a large
effect on the stock price, and that a large value for ‘a’ implies that an increase in the
stock market will have a large effect on output. Thus, the higher are these
parameters, the more likely it is that (15) will hold. Note that (15) is also more
likely to hold if 1 is large, which is to say, if output can adjust rapidly. Rapid
adjustment of output is necessary to ensure that the short-term real interest
differential is quickly reversed.
The smaller is ‘6’, the more likely is it that (15) will hold. Here b is the marginal
propensity to save out of current income; the smaller is this parameter, the larger is
the simple Keynesian multiplier; and the larger is this multiplier, the larger is the
positive effect of output on aggregate demand that is central to the intuitive
explanation for the ‘reverse overshooting’ identified above.
Condition (15) 1s unlikely to hold if the sensitivity of aggregate demand to the
real exchange rate, y, is large, because in that case an exchange rate appreciation
would have an important dampening effect on output, reducing the likelihood of
the strong, rapid output increase needed to bring about reversal of the interest rate
differential.
Finally, the ‘reverse overshooting’ scenario requires slow price adjustment. This
also is easy to understand. If price adjustment were very rapid, then money would
be approximately neutral and monetary expansion would have only a small effect on
output and real interest rates. There would not be a substantial effect on the stock
price, because output would not increase enough, or for a long enough period of
time, to significantly raise the discounted value of a claim on future profits. This
would eliminate the strong stock price-output-stock price linkage that generates
the ‘reverse overshooting’ scenario.

III. Fiscal Policy

I turn now to a discussion of the effects of aggregate demand disturbances, which I

will label ‘fiscal policy.’ The model is particularly well adapted to answer two
questions that have arisen in the literature.
 MICHAEL G.+VIN 189

First, it has been suggested that the covariance of stock prices and the exchange
rate can provide information on the relative importance of real versus monetary
disturbances to the economy, with the argument being that monetary disturbances
should lead to a positive correlation in these asset prices, while real disturbances
should lead to a negative correlation. 10 The model presented in this paper can
clarify the circumstances under which such a pattern of correlations is to be
expected. We shall see below that the answer depends not only upon whether the
economy is best characterized by the ‘good news’ or the ‘bad news’ assumption, but
also upon whether the aggregate demand disturbances tend to occur immediately
upon announcement, or if instead there is a significant delay between
announcement and implementation of the policy change.
A second question is whether anticipated future fiscal policy expansions are
contractionary or expansionary. A number of papers have pointed out the
possibility that an expected, future fiscal expansion may lead to a recession through
its effect on the real long-term interest rate or the real exchange rate.11 Blanchard
(1981) showed that in a stock-market economy this result need not hold; however,
he did so in the context of a closed-economy model in which the possibility of
‘crowding out’ via net exports did not exist. Below we determine the conditions
under which this contractionary effect of future fiscal expansions is reversed in a
stock-market economy that is open to international trade.
Preliminaries: In order to analyze anticipated and transitory fiscal disturbances, I
confine myself in this paper to the case in which 0 is very large, so that output
adjusts instantaneously to aggregate demand. This simplifies the analysis and
permits a graphical treatment of the model.12
Without output equal to aggregate demand, the economy can be represented by
two, rather than four dynamic equations:

where all of the parameters are defined as in Section II, except that the parameters
‘a’ and cs should be interpreted as the ‘a’ and c in equation (1) divided by ‘6’. This
redefinition is not substantive; it merely simplifies the notation. I show in part B of
the separate technical appendix that, under condition (13), there are two positive
roots to the characteristic equation for the Jacobian in (16), so that the saddle
‘path’ is a point in (0, q) space.
The dynamics of the model depend very much upon whether an increase in
output is ‘good news’ or ‘bad news’ for the stock market, and whether the stock
price or the real exchange rate is ‘more influential’ in goods markets. The purpose
of this section is to provide an intuitive understanding of how and why the stock
market effects can alter the behavior of the open-economy IS-LM framework. So,
rather than attempt a comprehensive discussion of all possible cases, I confine
myself in this section to two interesting cases: the ‘bad news’ case; and a ‘good
news’ case in which the stock market ‘matters more’ in goods markets than does the
real exchange rate. 13 The ‘good news’ case is likely to be more interesting on
empirical grounds, but the ‘bad news’ case is interesting for comparison with
existing versions of the dynamic, Mundell-Fleming model which, by assuming that
aggregate demand depends only upon a bond market, implicitly assume that the
‘bad news’ case is relevant.
Figure 3 shows the phase diagram for the ‘bad news’ case. The 0 = 0 schedule is
190 The stock market and exchange rate +amics

the locus of points for which the real interest rate equals the world interest rate. It is
also the set of points for which real output equals steady-state output. This is
because, with a constant price level and money supply, the domestic real interest
rate depends only upon real output. Thus, the interest rate is above the world rate if
and only if output is above the steady-state level.
A real exchange rate depreciation raises aggregate demand. To keep output and
the real interest rate at their steady-state level, an increase in the real exchange rate
must therefore be offset by a decline in the stock price. Thus, the o= 0 schedule is
downward sloping in both the ‘good news’ and the ‘bad news’ cases. Above the
schedule, output is high, and the domestic interest rate is as a result above the
foreign real interest rate. Asset market equilibrium requires that the real exchange
rate be depreciating, so that above the t?= 0 schedule, the real exchange rate must be
depreciating (d>O). B e lo w the schedule the real exchange rate must be
appreciating.
In the ‘bad news’ case, the j= 0 schedule is downward sloping and steeper than
the 8= 0 schedule. To see this, consider a move from the steady state, JJ’, to point
A which, being on the b= 0 schedule, represents an increase in the stock price with
no effect on output, profits or the interest rate. At A, the opportunity cost of
purchasing a share of the stock market, rq, has increased, but profits per share
(which depend only upon output) have not increased. Thus, equilibrium in the
capital market requires anticipated capital gains on stocks; that is, at A, g>O.
Moving from _4 to a point such as Bin the phase diagram leads to an increase in
output, and therefore both the interest rate and profits. By definition of the ‘bad
news case’ the interest rate rises proportionately more than the increase in profits,
so that at B an even larger rate of capital gain on equity would be necessary to
maintain asset market equilibrium, compared with A. On the other hand, moving
from A to a point like C, where output, interest rates and profits have fallen,
permits capital market equilibrium with no anticipated capital gains on equity.
Thus, in the bad news case the i= 0 schedule is necessarily downward sloping and
steeper than the r!I= 0. By similar reasoning, in the ‘good news’ case the i= 0
schedule is necessarily less steep than the 8=0 schedule, and it may be upward
sloping.
Figure 4 shows the phase diagram for the ‘good news case.’ Above the j= 0
schedule aggregate demand and output are high, which leads to higher profits and
interest rates. In the ‘bad news’ case, the interest rate effect dominates, and
restoration of capital market equilibrium requires anticipated capital gains (i> 0).
In the ‘good news’ case the profitability effect dominates, and anticipated capital
losses are required (4<0).14
A fiscal expansion affects the i= 0 and the 0 = 0 schedules in the same way in the
‘good news’ and ‘bad news’ cases; the increase in aggregate demand raises output
at a given stock price and real exchange rate. The 8= 0 schedule therefore shifts down,
as a reduction in the real interest rate to the world level requires a reduction in
output which, in turn, requires a reduction in either the real exchange rate or the
stock price. The i= 0 schedule shifts down by the same amount for the same reason.
Thus, the new steady state after arrival of a permanent fiscal expansion is at the same
stock price, but an appreciated real exchange rate.
The remainder of this section uses these phase diagrams to consider the
following experiment. At time T,, it is announced that there will be a fiscal
expansion beginning at time T, and lasting until T,. At T2fiscal policy returns to the
 MICHAEL GAVIN
191

FICCRE 3. Phase diagram: ‘bad news’ case

FIGURE 4. Phase diagram: ‘good news’ case

192 The stock market and exchange rate +amics

original setting. is I begin with analysis of a transitory, unanticipated fiscal

expansion, (TO= IT;), and then consider the case of anticipated policy changes
(T,<?;).
Unanticipated, Transitor_ Changes in Fiscal Pofiy: Figure 5 illustrates the dynamic
adjustment path to an anticipated, transitory fiscal expansion in the ‘bad news’ case.
Before and after the fiscal expansion, the economy is governed by dynamics
summarized in the upper schedules, and during the fiscal expansion it is governed
by the dynamics summarized by the lower schedules. In the case of an
unanticipated, permanent fiscal expansion, the economy jumps from SS, to SJ,,
and remains there. Thus, the only effect is on the real exchange rate and, therefore,
the composition of aggregate demand. As in the standard Mundell-Fleming model,
output, interest rates, and the stock price are unaffected.
Anticipated or transitory fiscal expansions lead to more interesting asset price
dynamics, which we now explore. Consider first the response of a ‘bad news’
economy to a transitory fiscal expansion that occurs immediately upon
announcement. By ruling out anticipated asset price jumps, we know that when the
fiscal expansion ends the economy must be at the initial and final steady state, SS,.
This means that during the transitory fiscal expansion the economy must be
somewhere on the curve labeled (A). This is the locus of points for which the
economy’s dynamics (as influenced by the fiscal expansion) lead through the point
SS,. Where on this curve the economy lands after announcement of the change in
fiscal policy depends upon how long the fiscal expansion is expected to last. If the
expansion lasts for a very long time, the economy must be very close to SS, when
the fiscal expansion is enacted; thus, very long fiscal expansions have effects similar
to permanent expansions. If the expansion is very short, the economy must be
somewhere near JS,, at time T,.
Several points are readily apparent from Figure 5 (and are proven in the technical
appendix to this paper). First, no matter how long the fiscal expansion lasts, the real
exchange rate must appreciate and the stock price decline. Thus, in the ‘bad news’ case,
disturbances to aggregate demand generate a positive correlation between stock
prices and the real exchange rate. The magnitude of the real exchange rate
appreciation is strictly increasing in the length of the fiscal expansion, while there is
a non-monotonic relationship between duration of the fiscal expansion and the
decline in stock prices, For very short fiscal expansion there is a large effect on
output, interest rates, and profits, the fundamental determinants of the stock price,
but these fundamentals change for such a short period of time that the present value
of the changes is small. For very large fiscal expansions there is, as in the static
Mundell-Fleming model, very little change in output or the interest rate until far
into the future; again, the present value of these anticipated changes in the
fundamental determinants of the stock price is negligible. Thus, very short and very
long fiscal expansions have only a small effect on the stock price, while fiscal
expansions of moderate duration have the largest, adverse effect on the stock
market.
Consider now the ‘good news’ case. In this case there are two important subcases
to consider. In the first, the stock market is more influential in goods markets than
is the real exchange rate. In the second, the real exchange rate exerts more influence
over the goods market. I will consider here the case in which the stock market is
more influential than real exchange rate.16
Figure 6 illustrates the dynamic adjustment of the economy to an anticipated,
 193

FIGURE 5. Dynamic adjustment to a future, transitory fiscal expansion:

‘bad news’ case

FIGURE 6. Dynamic adjustment to a future, transitory fiscal expansion:

‘good news’ case
194 The stock market and exchange rate hnamics

transitory fiscal expansion in the strong stock-market case.iTAs in Figure 5, the

economy must be on the curve (A) d uring the period when the fiscal expansion is in
force.
We can see from Figure 6 that, in this case as in the ‘bad news’ case, the exchange
rate must always appreciate relative to the original steady state during the fiscal
expansion. Output, profitability, and the real interest rate are always above the
steady state during the fiscal expansion. In the ‘good news’ case the effect of a
change in output on profitability dominates the interest rate effect, so the stock
price must increase. Thus, in the ‘good news’ case, disturbances to aggregate
demand generate a negative correlation between stock prices and the real exchange
rate.16 Since the ‘good news’ case is probably the empirically relevant one,*9 we
have provided an analytical basis for the presumption of such a negative correlation
by, for example, Obstfeld (1985). However, the basis for this presumption is
weakened when news of a demand shock arrives in advance of the shock itself, as we
now demonstrate.
Anticipated Polics, Changes: Because of the relatively cumbersome decision-making
process associated with fiscal policy in many countries, ‘news’ about a fiscal policy
change often arrives well in advance of the policy change itself. For this reason, it is
important to ask how anticipated future changes in fiscal policy affect the economy.
We begin by examining a ‘bad news’ economy, then consider the ‘good news’
economy.
We know from the above discussion that, during the time when the fiscal
expansion is implemented, the economy must be on the trajectory labeled ‘A’ in
Figure 5. Where it must be at the time the fiscal expansion is first implemented
depends upon the length of the fiscal expansion. Let us suppose that the length of
the fiscal expansion is such that the economy must be at point ‘a’ when the policy
change is implemented.
The assumption of rational expectations rules out anticipated ‘jumps’ in the stock
price or the real exchange rate. Thus, the economy’s behavior before the fiscal
expansion arrives is determined by the requirement that it land at point ‘a’ when the
fiscal expansion arrives; thus, between announcement and implementation of the
fiscal expansion, the economy must be somewhere on the trajectory labeled (B),
which passes through the point ‘a’. To which point on (B) the economy must jump
upon announcement of the future fiscal expansion depends upon how long is the
lag between announcement and implementation of the fiscal expansion. If the lag is
short, the economy jumps to a point near schedule (A). If the delay is very long,
then the economy must jump to a point on (8) that is very close to the original
steady state, and if the fiscal expansion is far enough into the future, the current
equilibrium is hardly altered at all.
Figure 5 suggests (and the technical appendis proves) that in the ‘bad news’ case
aggregate demand and output always decline between announcement and
implementation of the fiscal expansion; that is, in this case anticipated future fiscal
expansions are always contractionary. We know this from Figure 5 because the
economy is always below the original b = 0 schedule.) This decline in aggregate
demand is generated by a real appreciation that is itself caused by the fact that real
interest rates will be high during the period after implementation of the fiscal
expansion.
If the delay between announcement and implementation of the fiscal expansion is
long, then stock prices may rise in anticipation of the future fiscal expansion. The
 195

intuition for this possible increase in stock prices is straightforward: in the interim
between announcement and implementation of the fiscal expansion output and
interest rates are low which is, on balance, good for the stock market. But
stock-holders must also look forward to the period after the fiscal policy arrives
during which output and interest rates will be high. If the period of time between
announcement and implementation of the fiscal expansion is long, the favorable
effect on stock prices of the anticipatory recession will dominate, and stock prices
will rise. But if the delay is short, the recession will be short and the subsequent
boom imminent. Consequently, the adverse second-period effects will dominate,
and the stock price must fall upon announcement of the future fiscal expansion.
Note that when fiscal policy changes are anticipated, we can no longer say that, in
a ‘bad news’ economy, aggregate demand disturbances generate a positive
correlation between stock prices and asset prices. The sign of the correlation
depends upon whether ‘news’ of the future fiscal action arrives well in advance of
the policy change itself.
We now turn to the ‘good news’ case. As discussed above, the economy must be
on the schedule labeled (A) once the fiscal policy has been enacted, and at the
moment the fiscal policy change is enacted it must be at a point like ‘a’ in Figure 6,
where the location of ‘a’ depends upon the length of the fiscal expansion. Figure 6
has been drawn for a fairly long fiscal expansion, so that the point ‘u’ is fairly far
from the point JJ,,. If the fiscal expansion is expected to be short, at the moment the
fiscal expansion arrives the economy would have to be at a point like ‘b’ in Figure 6,
which is closer to JJ’,.
In the first case, between announcement and implementation of the fiscal policy
change the economy must be on schedule (EI) so that it lands at the point ‘a’ at the
moment that the fiscal expansion arrives. In the second case the economy must be
on the trajectory that passes through the point ‘b’. Note that every point on ‘B’ is
below the 8= 0 schedule, and therefore corresponds to a point of low output.
Similarly, it is apparent from Figure 6 that if the delay between announcement and
implementation of the future fiscal expansion is long, the economy will go into
recession even if it is expected that the fiscal expansion will be short. On the other
hand, if the delay between announcement and implementation of the fiscal
expansion is short, the economy will jump to a oint like ‘c’ upon announcement of
the future expansion which, being above the i = 0 schedule, represents a point of
high output.
Thus, whether output rises or falls upon announcement of the future fiscal
expansion depends upon

1. The length of the expected future expansion.

2. The delay between announcement and implementation.
3. Whether the economy is characterized by the ‘strong stock-market’ or ‘weak
stock-market’ assumption.

Specifically, we have the following result: if the fiscal expansion is expected to last
for a short period of time, and the delay between announcement and
implementation of the expansion is short, and the economy is characterized by the
‘strong stock-market’ assumption that aA + dy > 0, then output increases upon
announcement of the fiscal expansion.
This reversal of the ‘anticipatory recession’ result occurs for a perfectly intuitive
reason.20 Stock-holders look forward to the increase in output during the fiscal
19B The stock market and exchange rate &zamics

expansion, which is good for stock prices. If this favorable effect on stock prices is
large enough, then stock prices may rise upon announcement of the future fiscal
expansion, leading to an investment-led increase in aggregate demand and output.
The interesting question is why the conditions for future fiscal policy to be
expansionary are so stringent.
The fiscal expansion must be short because, as discussed above, long fiscal
expansions generate large exchange rate appreciations, and consequently have small
effects on output and profitability. With small effects on profitability, the stock
price will not increase much, and may even fall upon announcement of the future
change in fiscal policy. In any case, the stock price will not increase by enough to
offset the adverse consequences of real exchange rate appreciation on aggregate
demand. On the other hand, if the fiscal expansion is short it will generare only a
small exchange rate appreciation, and will have a large, favorable effect on
profitability and stock prices.
It is important that the delay between announcement and implementation of the
fiscal expansion be short because the less imminent is the fiscal expansion, the less
its effect on profitability will count in stock-holders’ present-value calculations.
Finally, it is easy to see the importance of assuming the ‘strong stock-market’ case
by noting that the effects on aggregate demand of stock prices and the real exchange
rate are offsetting. It turns out that not only must the stock price increase by enough
relative to the appreciation of the real exchange rate, but the impact of stock prices
on aggregate demand must also be large enough relative to the impact of exchange
rate changes on aggregate demand.
I note finally that, when the delay between announcement and implementation of
the fiscal expansion is long enough, the stock price may actually fall upon
announcement of the fiscal expansion. This is because, when the delay is long, there
will be an anticipatory recession while the economy waits for the fiscal stimulus. If
this recession lasts long enough, it is possible for the present value of the temporary
reduction in profitability to outweigh the present value of the eventual increase in
profitability when the fiscal expansion actually arrives. In this case, the stock price
falls upon announcement of the future fiscal expansion, even though fiscal
expansion is ‘good’ for the stock market. This result underscores the important
general point that the covariation of asset prices depends not only upon the nature
of the shocks that perturb an economy, but also upon how long is the lag between
announcement and implementation of the shock.

IV. Conclusion

This paper analyzed a model of the small, open economy in which the stock market,
rather than the bond market, determines aggregate demand. It was shown that the
asset price and output dynamics can differ in interesting ways from more
conventional dynamic, Mundell-Fleming models. In particular, the interaction of
output, profitability, stock prices and aggregate demand tends to dampen the
exchange rate implications of shifts in monetary policy. Indeed, if these stock
market effects are large enough, and if money is not ‘too neutral,’ it is theoretically
possible for an expansionary monetary policy to lead to real exchange rate
appreciation, rather than depreciation.
 hkHhEL GAVIN 197

In contrast to models with only a bond market, anticipated fiscal expansion can
lead to an anticipatory output expansion, rather than contraction. The reason for
this is that the anticipated expansion, by generating a future period with high
profits, leads to an increase in the current stock price, which in turn leads to an
expansion in aggregate demand and output. In this case the anticipatory expansion
is fueled by an investment boom; for it to happen, it was shown that the ‘good
news’ case must be the relevant one, the anticipated fiscal expansion must be short
enough, and its arrival cannot be too far into the future.
In the empirically relevant ‘good news’ case, and when aggregate demand shocks
are unanticipated, it was shown that such disturbances tend to generate a negative
correlation between the stock price and the real exchange rate. However, if the
delay between announcement and implementation of a fiscal policy disturbance is
long, it is possible that the correlation will become positive. In this case, the
correlation between stock prices and the real exchange rate would provide little
information about the relative importance of monetary versus aggregate-demand
disturbances.
This theoretical analysis leaves open the question of the empirical relevance of
the identified theoretical linkages. A convincing empirical analysis would probably
require a much more complete model that includes complications such as /-curve
effects, lags in the response of investment to fluctuations in stock-market
valuations, money-demand dynamics, a more convincing formulation of price-
setting, and a wide variety of other complications that have been found to matter in
more conventional macroeconomic models. Such an analysis has not been done.
However, in Gavin (1986) plausible values were attached to the parameters of the
theoretical model outlined in this paper. This exercise should provide some
preliminary insights into the empirical importance of some of the mechanisms
identified in the theoretical model.
First, it seems very likely that the ‘good news’ case is the empirically relevant one.
Second, although the necessary condition for the ‘reverse overshooting’ result,
(15), did appear to hold, the ‘reverse overshooting’ behavior did not arise until the
speed of price adjustment, 6, reached an implausibly low level.21 Thus, the model
generated a normal exchange rate response to monetary expansion not because
stock-market effects were too weak, but rather because money was ‘too neutral.’
For fiscal policy, the model suggested that reversal of the ‘anticipatory recession’
emphasized by Branson et al. (1985) app ears plausible. This conclusion is
buttressed by the presumption that sensible modifications of the model, for
example, using an expenditure deflator in the money demand equation and
recognizing the empirical lags between exchange rate changes and movements in
net exports, would tend to strengthen the positive impact of an expected future
fiscal expansion on current aggregate demand.22
The reader need not be reminded that this analysis is in many respects quite
incomplete. In particular, it shares in both the strengths and the deficiencies of all
variants of the Mundell-Fleming analysis .*3 In addition, the assumption of perfect
foresight prohibits any discussion of risk or portfolio considerations in the pricing
of stocks and bonds, and in the determination of the real exchange rate. By shedding
light on some determinants of the covariation of asset returns in response to ‘news’
about monetary shocks .and the state of aggregate demand, the analysis may
nevertheless constitute a useful first step on the way toward a full, stochastic
analysis.
198 The stock market and exchange rate &namics

Notes

1. After completing this paper a related paper by Jiirg Niehans (1987) came to my attention. Our
analyses are complementary, in that his paper assumes that prices are perfectly flexible, and that
the real exchange rate is fixed, while this paper pays particular attention to real exchange rate
dynamics in the context of a model with transitorily sticky prices. (Throughout this paper the real
exchange rate is defined as the price of foreign-produced goods in terms of home-produced
goods.)
2. The standard references are Tobin (1978) and Hayashi (1982). Unlike these papers, I neglect the
important distinction between average 4, which affects wealth, and marginal q, which affects
investment. Fischer and Merton (1984) document a strong empirical link between movements in
the stock market and subsequent movements in output, and numerous studies of both investment
and consumption also find significant stock-market effects.
3. While Tobin’s qis, in theory, a sufficient statistic for investment demand, it is possible that the real
interest rate affects consumption demand. This possibility is ruled out in (1). As is well known, it
is difficult to find empirical support for the proposition that consumption is strongly affected by
the real interest rate. Thus exclusion of the real interest rate from (1) may be a good
approximation to reality in the USA.
4. It is noteworthy that, while output is transitorily ‘sticky, ’ it is assumed that the composition of
expenditure can change instantaneously. It would be more realistic to recognize that investment
responds only gradually to changes in q (see Fischer, 1984) and that net exports respond slowly to
changes in the real exchange rate. These dynamics would alter the model’s properties
significantly, and would also make the analysis intractable. However, such issues could be
pursued in the context of a simulation model (see, for example, Branson et al., 1985).
5. Money demand depends upon the nominal, rather than the real interest rate. However, I rule out
sustained monetary growth, so that the steady state nominal interest rate is equal to the steady
state real interest rate.
6. Note that real balances are deflated with the price of home output (value-added), rather than an
expenditure deflator which would, given wages, depend upon the real exchange rate. The
consequences of making the alternative assumption are well established in the literature (see, for
example, Branson and Buiter, 1983), so for now I make the simpler assumption embodied in (6).
7. However, as Frenkel and Razin (1987) p oint out, the Mundell-Fleming model is unsuited for
analysis of permanent changes in fiscal policy, because it does not account for wealth effects of
fiscal and external imbalances. In the section on fiscal policy, I consider temporary, rather than
permanent changes in fiscal policy.
8. The ‘saddle path’ is, in this case, a two-dimensional subspace of the four-dimensional space
spanned by the model.
9. However, as will be discussed below, it is possible that the long-term real interest rate increases
after the monetary expansion, so this result is less obvious than it might appear at first glance.
10. See, for example, Obstfeld (1985).
11. See, for example, Burgstaller (1983), Blanchard (1984), and Branson et al. (1985).
12. Gavin (1986) contains simulation analyses of the case in which the adjustment of output to
changes in aggregate demand is less than immediate.
13. I also limit myself to cases in which the roots are real, so that the economy does not exhibit cyclical
behavior. The technical appendix discusses conditions under which the roots are complex, and the
simulation experiments discussed in Gavin (1986) s h ow that the qualitative properties of the
model are broadly similar when the roots are complex.
14. The graphical analysis also requires further knowledge about the way in which the economy
would ‘explode’ off the ‘saddle point.’ In particular, we need to know the relative slopes of the
eigenvectors corresponding to the two eigenvalues. For example, in the bad news case it happens
that the eigenvector corresponding to the larger of the eigenvalues is positively sloped in (8, q)
space. This is why, in Figure 3, almost all points off the steady state ‘explode’ in a northeast or
southwest direction. Although this information underlies the way Figures 3 through 6 are drawn,
it is of no intrinsic interest, so I have relegated a discussion to the technical appendix.
15. Transitory fiscal expansions are interesting because permanent fiscal expansions imply an
exploding public debt, and should therefore be ruled out; anticipated fiscal policy is interesting
because of the interest generated by several papers that discuss the contractionary impact of
anticipated fiscal expansion. Note that there is nothing restrictive about the assumption that the
fiscal expansion is ‘transitory’ or ‘anticipated.’ A permanent fiscal expansion is the special case in
which T, is infinite, and an unanticipated fiscal expansion is the case in which (TI -TO) is zero.
 MICHAEL GAVIN 199

16. In this case, aA+ri<O, which can be interpreted as a condition that the stock market is more
‘influential’ in goods markets than is the real exchange rate. To see this, consider a one-period,
unit increase in output. The stock price would, through interest rate and profit effects, increase by
-A, which would, in turn, raise aggregate demand by ‘II’ times -A. The one-period increase in
output would also raise the real interest rate, and lower the real exchange rate, by ‘c’. This, in turn,
would lower aggregate demand by ‘c’ times y. If -aA>ry, then the favorable effect on aggregate
demand from the stock-market increase would be larger than the unfavorable impact of the real
exchange rate appreciation.
17. See Gavin (1986) for a more exhaustive treatment of the various subcases.
18. Analogous to the ‘bad news’ case, and for the same reasons, the impact of a transitory fiscal
expansion on stock prices is small for very short or very long fiscal expansions, while there is a
large (positive) effect on stock prices when the fiscal expansion is of moderate length.
19. In fact, the empirical literature on the impact of ‘news’ about real economic activity on stock
prices is mixed. Hardouvelis (1987) fmds that, while stock prices in the USA respond positively to
favorable news about personal income, there is no evidence that they respond to news about
industrial production or the unemployment rate. Similarly, Pearce and Roley (1985) also fail to
uncover a relationship between stock prices and news about real economic activity. On the other
hand, using data over a much longer time horizon, Cutler et al. (1988) find evidence that stock
returns are positively correlated with favorable news about real output. These findings should not
be interpreted as direct evidence on the question whether the US economy conforms to the ‘good
news’ or the ‘bad news’ case, because that theoretical question holds monetary policy constant,
whereas the market response to news presumably incorporates expectations about the monetary
authorities’ subsequent reaction to the news.
20. Indeed, in the closed-economy case analyzed by Blanchard (1981), an anticipated fiscal policy
expansion was necessarily expansionary in the ‘good news’ case. That result differs from the
present analysis because, with no foreign sector, there was in his model no possibility ofcrowding
out aggregate demand through a reduction in net exports-n important feature of this model.
21. It required price adjustment so sluggish that monetary policy involves substantial non-neutralities
after ten to fifteen years, which seems highly implausible.
22. If money demand were deflated by an expenditure deflator, then the real exchange rate
appreciation that is generally implied by fiscal expansion would effectively increase real balances,
having a positive effect on output.
23. See Frenkel and Razin (1987) for a comprehensive discussion of these shortcomings.

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