The Stock Market, Monetary Policy, and Economic Development

In this paper, we examine the impact of financial market development on capital accumulation and inflation. In particular, we explore this issue in a setting in which banks provide risk pooling services. Furthermore, money overcomes incomplete information to facilitate transactions between individuals. In contrast to previous work, we incorporate a market for equity by allowing individuals to trade capital across generations. Interestingly, we find that the quantitative impact of the stock market may be indeterminate — the economy may respond with significant gains in capital accumulation or relatively little. Consequently, it is not clear how much financial development will drive down inflation in the longrun. In the case of unique steady-states, expansionary monetary policy causes long-run capital accumulation to fall. However, the response is much stronger in the presence of a stock market. Furthermore, the market for capital may lead to a different qualitative response to monetary policy. That is, financial development may lead to a Tobin effect from inflation. Finally, by studying dynamics, we demonstrate that financial markets and monetary policy can have a significant impact on volatility in the economy. In this manner, there is additional scope for monetary policy to stabilize the economy at higher levels of financial development.