Output Interest and the Stock Market: An Alternative to the Jump Variable Technique

Abstract

The paper reconsiders an influential model by Blanchard (1981) that extends the textbook ISLM framework by including among the financial assets, besides money and short-term bonds, also long-term bonds and equities. Aggregate demand is supposed to vary with Tobin's (average) q, rather than the real interest rate. Accordingly, the model emphasizes the dynamic interaction between real output and share prices. The present treatment departs from Blanchard in that the nonmoney assets are no longer presumed to be perfect substitutes, and the forecasts of capital gains are no longer unboundedly rational. On this basis an alternative approach to the conventional jump variable technique (saddle path stability) is derived. It is necessarily global in nature and, under a suitable nonlinearity on the stock market, typically gives rise to endogenous cyclical behavior. In the limit case of myopic perfect foresight of capital gains, the model exhibits relaxation oscillations.