Academic journal article Quarterly Journal of Business and Economics

The Dynamic Interaction between Equity Prices and Supply Shocks

Academic journal article Quarterly Journal of Business and Economics

The Dynamic Interaction between Equity Prices and Supply Shocks

Article excerpt


Real stock prices have been fluctuating significantly around an upward trend on frequencies of approximately 25-years duration in most of the industrialized countries over the past century (Siegel, 2002; Shiller, 2001). Although no systematic investigation of forces that may have been responsible for these large swings have been undertaken, large swings in stock prices often have been associated with technological revolutions (Hobijn and Jovanovic, 2001; Madsen and Davis, 2006; Shiller, 2001).

In the models of Hobijn and Jovanovic (2001) and Madsen and Davis (2006), stock prices of incumbents are influenced adversely by a technological revolution due to creative destruction, whereas entrants experience no decrease in stock prices as they benefit from the higher productivity of the new technology. Due to a long time lag between the innovation and the entrance of new firms in the Hobijn and Jovanovic (2001) model, technological revolutions will result in large swings in aggregate stock prices. Madsen and Davis (2006) argue that technological revolutions tend to generate large swings in stock prices because the stock market focuses on the incorrect earnings indicators and uses the incorrect valuation model.

This paper argues that swings in the distribution of income between capital and labor, like technological revolutions, may be influential for the large low frequency swings in stock prices. The leading idea is that profits may be low over a prolonged period because wage-push factors (such as union militancy and supply shocks that bring real wages in excess of workers' marginal productivity) result in distribution of income in favor of labor and, consequently, depress stock markets. Conversely, stock markets are buoyant in periods of cooperation between unions and firms and when beneficial supply shocks bring labor's share of income below its long-run equilibrium.

A macroeconomic framework for analyzing the dynamic interaction between the stock and the labor markets is established. The model extends Blanchard's (1981) model of the interaction between stock prices and output by allowing for the influence of the supply side. The supply side plays the dual role of determining the distribution of income between wages and profits and of ensuring that profits are neutral to supply shocks in the long run.

The supply side is incorporated into the model using the augmented Phillips curve framework. The model shows that supply shocks are influential for movements in earnings in the short run and in the medium term, and that demand shocks only play a role for fluctuations in stock prices on business cycle frequencies. The model incorporates into stock prices the empirical regularity that earnings per unit of capital are neutral to shocks in the long run. An adverse supply shock that pushes wages in excess of the full employment equilibrium simultaneously increases unemployment and squeezes the firm's cash flow. Higher unemployment reduces the wage growth rate, which in turn increases cash flow until the natural rate of unemployment is reestablished. Due to sluggish adjustment in the labor market, the model embodies into stock prices that the reduction in earnings is temporary and therefore leads to a substantially smaller reduction in stock prices than would be predicted by the myopic Gordon growth model.

Low Frequency Movements in Stock Prices

Using data for 11 industrialized countries over the period from 1900 to 2002 this section shows informally how stock prices are influenced by capital's share of total income and the innovative activity. Here, capital's share in total income is defined as nominal GDP minus compensation to employees divided by GDP, and labor's share is compensation to employees divided by GDP. To preserve space, only the weighted averages of all eleven countries are shown. Formal testing with disaggregated data is undertaken in the empirical section below. …

Search by... Author
Show... All Results Primary Sources Peer-reviewed


An unknown error has occurred. Please click the button below to reload the page. If the problem persists, please try again in a little while.