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

The paper reconsiders an influential model by Blanchard (1981) that extends the textbook ISLMframework 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 interactionbetween real output and share prices. The present treatment departs from Blanchard in thatthe nonmoney assets are no longer presumed to be perfect substitutes, and the forecasts ofcapital gains are no longer unboundedly rational. On this basis an alternative approach tothe conventional jump variable technique (saddle path stability) is derived. It is necessarilyglobal in nature and, under a suitable nonlinearity on the stock market, typically gives rise toendogenous cyclical behavior. In the limit case of myopic perfect foresight of capital gains, themodel exhibits relaxation oscillations.