Linking Real Activity and Financial Markets: The Bonds, Equity, and Money (BEAM) Model

The authors estimate a small monthly macroeconometric model (BEAM, for bonds, equity, and money) of the Canadian economy built around three cointegrating relationships linking financial and real variables over the 1975–2002 period. One of the cointegrating relationships allows the identification of a supply shock as the only shock that permanently affects the stock market, and a demand shock that leads to important transitory stock market overvaluation. The authors propose a monetary policy reaction function in which the impact of a permanent inflation shock on the overnight rate is simulated and the future path of the overnight rate adjusted accordingly, to prevent any forecast persistent deviation from the inflation target. They introduce a technical innovation by showing under which conditions permanent shocks can be identified in a vector error-correction model with exogenous variables.