The Equity Price Channel in a New-Keynesian DSGE Model with Financial Frictions and Banking

Working paper 360
Hylton Hollander and Guangling Liu
Publication date: 
July, 2013
Economic Modelling

This paper studies the role of the equity price channel in business cycle fluctuations, and highlights its systemic risk across all sectors of the economy. We develop a canonical New-Keynesian dynamic stochastic general equilibrium model with a tractable role for the equity market in banking, entrepreneur and household economic interactions. The model is estimated with Bayesian techniques using U.S. data over the sample period 1982Q01 - 2012Q01. We show that a New-Keynesian DSGE model with an equity price channel well mimics the U.S. business cycle. Moreover, the equity price channel significantly exacerbates business cycle fluctuations through both the financial accelerator and bank funding channels. This study highlights the equity price channel as a different aspect to general equilibrium models with financial frictions, and emphasizes the consequences of the (in)stability of financial markets on the real economy.

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