Linking Real Activity and Financial Markets: BEAM model1

A small monthly macroeconometric model of the Canadian economy built around three cointegrating relationships linking financial and real variables is estimated over the 1975-2002 period. One of the cointegrating relationships allows the identification of a supply shock as the only shock affecting permanently the stock market and a demand shock leading to important transitory stock market overvaluation. We also suggest a monetary policy reaction function using the estimated impact over time of the typical permanent inflation shock to modify the historical reaction function in such a way to eliminate any forecast persistent deviation from target. In-sample simulations over the last ten years suggest that following BEAM’s advice would have cut by more than half the root-mean squared deviation of inflation from target over the period. A technical innovation of the paper consists in showing under which conditions permanent shocks can be identified in a VECM with exogenous variables.