Productivity Shocks, Innovations, Stock Market Dynamics and Growth

The banking business in the late 20^th century has undergone profound changes. A first aspect is that the speed of adjustment in financial markets has increased in the course of digitization, computer expansion and the internet revolution, at the same time bringing down heavily prices of transactions in financial markets and thus contributing to the internationalization of financial markets and banking. A second key aspect is economic globalization with the result that for many financial products there exists a global market in which only a few large banks compete. A third element is that prudential supervision has started to emphasize risk-based equity requirements – indeed, Basel II rules will bring about broader spreads across different classes of loan risk. A fourth element is the increasing role of investment banking and the role of international mergers & acquisitions which accounted for roughly 3/5 of foreign direct investment in the 1990s. This in turn reinforces the role of stock markets on whose dynamics our analysis will focus. Moreover, in the presence of imperfect capital markets there is a renewed interest in the development of the real exchange rate since it will affect foreign direct investment: FROOT/STEIN (1991) have emphasized that a real depreciation of the currency of the host country implies that equity capital of foreign bidders – expressed in terms of the currency of the host country - is increased so that a successful leveraged international M&A will become more likely; FDI inflows will increase. Defining the real exchange rate of country I (home country) as q = P/eP* or q* = eP*/P where e is the nominal exchange rate and P the price level (*denotes foreign variables) it is clear that both nominal exchange rate dynamics and changes in the sticky price level at home and abroad will affect the real exchange rate. Our analytical focus will be partly on short term stock market dynamics in open economies which we define as having trade and foreign direct investment inflows. We will present a new short term model which models the interaction of money market, stock market and foreign exchange rate. Moreover, a medium term model based on the capital asset pricing model will be presented and finally we will plug the stock market into a modified growth model. Indeed, we will emphasize the role of stock markets for short-term and long term dynamics.