The dynamic adjustments of stock prices to inflation disturbances

Journal of Economics and Business (2012) 64(2):117-144
Abstract: While theoretical predictions establish a strong positive relationship between equity prices and inflation, finding substantiating empirical evidence has been a difficult endeavor. Generally, the data suggests a weak negative relationship between stock prices and inflation. Aided by two different structural VAR specifications that allow for time variation in the covariance and drift of the system, this paper finds evidence that the weakly negative correlation between stock prices and US inflation results from offsetting effects of shocks to monetary policy and disturbances to the demand for financial assets. Since the 1960s, the stock price-inflation correlation is estimated to be relatively more stable than the volatility of either series, both of which have experienced substantial change—albeit volatility in US economic activity is estimated to have taken place far more gradually than that of stock prices. The volatilities of US economic activity, inflation, and stock prices all rose as a result of the financial crisis and the ensuing 2008–2009 Great Recession—with the level of inflation volatility estimates during the Great Recession comparable to those of the Great Inflation period of the 1970s. While it is shown that a traditional VAR approach would also predict a positive stock price response to inflationary disturbances, our time-varying approach enables us to uncover that during the 2008–2009 Great Recession period a stock price increase is more pronounced following inflationary shocks that stem from money supply, rather than money demand, disturbances—in contrast to the 1980–1982 recession where the magnitude of the stock price response to both shocks is more similar. These conclusions are qualitatively robust to changes in variable choice and measurement frequencies.

The Impact of Government Spending on Private Spending in a Two-Sector Economy
Public Finance Review (2012) -in Press

Abstract: Based on evidence that the dynamics of private spending on durables seem to differ from that of nondurables and services, this article disaggregates the impact of an exogenous government shock into its effect on each type of consumption good. Different calibrations of a dynamic stochastic general equilibrium (DSGE) model suggest that increases in government spending crowd out private spending on durable goods, while they serve to expand nondurable and services spending. Vector autoregression (VAR) estimates across these sectors yield qualitatively similar results. The estimated responses are driven by a negative correlation between durable spending and two measures of government spending that has not greatly varied over time—whereas the correlation between nondurable spending and government consumption has remained consistently positive throughout the sample. Estimates are consistent with a Great Moderation in three components of consumption, whereas moderations in the volatility of government spending took place earlier than the 1980s. The Great Recession of 2008–2009 saw an increase in volatility of consumption spending with no similar increases in the uncertainty of government spending.

Greater Moderations  (with John Keating)

Economics Letters (2012) 115(2):168-171
Abstract: Using a 219-year sample, we find that the US output growth and inflation volatilities fell by 60% and 76%, respectively, from 1945 until the mid-1960s. This Postwar Moderation is more substantial than the Great Moderation. The largest reduction in inflation volatility occurred during the Classical Gold Standard period. Our empirical model implies that aggregate supply accounts for most of the changes in output growth volatility while aggregate demand accounts for most of the changes in inflation volatility.

Fluctuations, Uncertainty and Income Inequality in Developing Countries  (with Fadi Fawaz and Masha Rahnamamoghadam)

Eastern Economic Journal (Fall 2012) 38(4):495-511

Abstract: We analyze income inequality and high frequency movements in economic activity for low and high income developing countries (LIDC and HIDC). The impact of human capital, capital formation, and economic uncertainty on income inequality for LIDC and HIDC are also evaluated. We find strong evidence that business cycle fluctuations serve to exacerbate income inequality in HIDC while they help narrow the gap in LIDC. Importantly, volatility in output widens inequality across the board but to a consistently higher degree in HIDC. Schooling helps reduce income inequality in both country groups, while investment increases income inequality. Lastly, the Kuznets inverted U-curve hypothesis is confirmed for both LIDC and HIDC.

Working Papers

Work in Progress