Introduction

Equity prices and equity markets are major sources of shocks to the world economy and major channels for the propagation of these shocks. In this chapter we seek to calibrate their effects, and assess what policy responses can best absorb them. We first briefly discuss the evidence for the effects of equity prices on real economic activity and look at some evidence on the relationship between equity prices and output using Vector Error Correction (VECM) Models. We compare these results for the US and the major euro area countries to those produced using the National Institute Global Econometric Model (NiGEM). We assess the implications of equity price falls comparable to those seen in 2000–2002 in the context of NiGEM, presenting a range of simulations on the model. These give a view of the macroeconomic impact of equity market falls, viewed in the context of the high degree of correlation between equity price changes in the recent past, and also give an indication of the effect of differing policy responses.

The macroeconomic importance of equity markets

There is a significant literature investigating the impact of wealth – itself driven partly by share prices – on consumption. Davis and Palumbo's (2001) study of the US consumption function attempts to determine whether changes in wealth affect the growth rate of consumer spending. They examined quarterly aggregate US data from 1960–2000 and modelled long-run relationships to investigate whether (logged) consumption, income and wealth share a common trend.