Permanent and Temporary Components of Stock Prices: Evidence from Assessing Macroeconomic Shocks

Abstract

This paper outlines a simple macro model with overlapping wage contracts to investigate how the temporary and permanent components of stock price movements may be related to aggregate macro‐economic supply and demand disturbances. In the content of the model, we show that aggregate demand shocks have only temporary effects on real stock prices, while supply shocks may affect the level of real stock prices permanently. Moreover, the temporary component in U.S. stock prices, identified by placing appropriate structural restrictions on a vector autoregressive system estimated for the postwar period, is statistically significant. This evidence supports the mean‐reversion hypothesis that stock prices are not pure random walks. The finding is robust to the choice of variables used in the vector autoregressive system and periodicity.

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