“Asset Prices and Macroeconomic Outcomes: A Survey”

That’s the title of an excellent review authored by two leading experts, Stijn Claessens and Ayhan Kose, that is required reading for anyone who wants to glean the implications of asset price movements for what’s going to happen in the real economy. From the conclusion:

Challenges to theoretical and empirical findings. The links between asset prices and activity differ from the predictions of standard models in a number of ways. First, asset prices are much more volatile than fundamentals would imply and can at times deviate, or at least appear to do so, from their predicted fundamental values. The term structure of interest rates is not fully consistent with the simple expectation hypothesis. Although exchange rates can be modelled as the present value of expected fundamentals, they appear to be overly volatile,
as is the case between equity prices and their underlying dividend streams (the puzzle of “excess volatility”). Moreover, macroeconomic and financial news seem to have an exaggerated effect on asset prices: equities, bonds and currencies overreact to news about cash flows and other fundamentals.

Second, investment and consumption respond differently to asset prices from what standard models would suggest, with a larger role for “non-price factors” in driving agents’ behaviour and macroeconomic aggregates. Firm investment reacts less strongly to asset prices than predicted by models while household consumption reacts more vigorously to changes in asset prices, especially house prices, than consumption-smoothing models would suggest. In addition, the links between asset prices and macroeconomic outcomes appear to vary across countries depending on financial, institutional and legal structures. Research also questions
the strength of the direct impact of interest rate changes on activity and highlights its dependence on the state of the economy and the financial sector, and institutional arrangements. Recent studies emphasize the importance of uncertainty (measured among
others by the volatility of asset prices) in explaining macroeconomic outcomes.

Third, there are limits to the predictive ability of asset prices for real activity. The basic theory implies that asset prices should be good proxies for expected growth as they are forward-looking variables. Equity prices, however, with their low signal-to-noise ratio and their (excess) volatility, have a mixed record in forecasting activity. There are also limits to the predictive ability of the yield curve, which depends on the time horizon, country-specific circumstances and external factors. Although this remains a topic of intense research, recent studies suggest that movements in exchange rates help only to a limited degree in predicting changes in fundamentals.

Fourth, similar to the domestic context, there are many puzzles involving the international dimensions of asset prices. As is the case for the weak link between equity prices and firms’ fundamentals within a country, comovements in asset prices appear to not (just) reflect commonality in cash flow streams. The observed high correlations across asset prices suggest other channels of transmission, including contagion, as suggested by the high volatility of capital flows. The limited international diversification of investment, the so-called home bias, has been hard to reconcile with the predictions of most asset pricing models.

Fifth, recent research emphasises the important role played by financial imperfections in explaining the linkages between asset prices and macroeconomic outcomes. Such imperfections appear to curtail households’ ability to borrow against future labour income, leading to liquidity constraints. Similarly, asset prices affect firm behaviour, including their willingness and ability to issue new equity, in ways suggestive of financial frictions. Imperfections also appear to amplify and propagate movements in asset prices (including through changes in agents’ balance sheets). Moreover, financial factors and imperfections seem to influence the linkages between exchange rates and macroeconomic outcomes.

I’m adding it to my reading list for my course on the financial system. If you’re teaching finance/macro, you should too!

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