Working Paper no. 188
By Stephen P Millard and Simon Wells
In this paper we construct a framework within which we can assess the ability of asset prices to convey information about the underlying shocks hitting the economy. We first use an identified VAR to establish a set of ‘stylised facts’ as to how asset prices respond to exogenous monetary policy movements. We then develop a theoretical model of the economy and analyse how asset prices within it respond to different shocks. Consumers in the model consume both market-produced and home-produced goods. There are two types of firms: those producing traded goods – sold on competitive world markets – and those producing non-traded goods. Non-traded goods’ producers face costs of adjusting their capital stocks and can only reset their prices once a year in a staggered fashion. We show that the model is able to replicate the ‘stylised facts’ found in the empirical exercise. We then show how asset prices respond to shocks to productivity in the traded, non-traded and household production sectors and a shock to the world price of traded goods. With these results we are able to assess what information asset prices may give us about the shocks affecting the economy at any particular time.