A discrete-time dynamic model of real-financial markets interactions

The global recession triggered by the great financial crisis and the response to the COVID-19 emergency have renewed the interest in connecting business cycle dynamics to financial conditions. This paper proposes a simple macro-dynamic behavioural model of the interaction between the stock market (SM) and the economy’s real sector (RS). We innovate by studying the interaction between two alternative sources of persistent fluctuations related to two different types of heterogeneity. The SM is modelled as a market with two heterogeneous speculators – chartists and fundamentalists. On the other hand, the RS is formalised as a simplified discrete-time version of Goodwin’s growth cycle model, distinguishing between labour and capital incomes. The interaction between the RS and the SM is the result of two assumptions: (i ) investment decisions depend on both profits and the stock price; (ii ) the fundamental value of the latter which is used by speculators in their demand functions is proportional to national output. The overlap between financial and real dynamics results in a novel source of economic fluctuations. We show that the dynamics generated by the resulting 2D map depend crucially on the sensitivity of investment to the stock price and a parameter entering the relation between the fundamental value of the stock price and national output.