The Stock Market, Monetary Policy, and Economic Development

[Author Affiliation]Edgar A Ghossoub, * Department of Economics, University of Texas at San Antonio, San Antonio, TX 78249, USA; E-mail: Edgar.Ghossoub@utsa.edu .Robert R Reed, [dagger] Department of Economics, Finance, and Legal Studies, 200 Alston Hall, University of Alabama, Tuscaloosa, AL 35487; E-mail: rreed@cba.ua.edu ; corresponding author.[Acknowledgment]We thank two anonymous referees and the co-editor, Kent Kimbrough, for their insightful comments.1. IntroductionA vast amount of research in macroeconomics studies the role of financial markets for economic development. For example, King and Levine (1993) document that active banking systems help economies achieve higher rates of growth.1 In addition to banking systems, other measures of financial development are important. Notably, Levine and Zervos (1998) conclude that stock market liquidity promotes activity.2 However, Minier (2003) identifies nonlinearities in the relationship between stock market activity and growth. In particular, Minier concludes that there are threshold effects from financial development to economic performance--beyond a threshold level of financial development, growth and stock market activity are positively related. However, the correlation is not observed in countries with small stock markets. Consequently, access to a stock market may result in a significant increase in economic activity or it may have little impact.3In addition to the stage of financial development, monetary policy also affects the development process. While initial studies indicate that inflation is generally associated with slower economic progress, more recent research concludes that the effects of monetary policy vary across countries. Bae and Ratti (2000) observe that higher rates of money growth are correlated with lower levels of output in Argentina and Brazil. In contrast, Bullard and Keating (1995) point out that inflation may be associated with an increase in output in low-inflation countries. In particular, the recent work of Ahmed and Rogers (2000) finds evidence of a Tobin effect for the United States.4,5Why does the impact of financial development vary across countries? Furthermore, why does the effect of monetary policy also differ across countries? In this article, we demonstrate that the impact of financial development depends on the services provided by various financial markets. That is, the economic functions of banks may be substantially different than stock markets. Although different types of financial markets fulfill unique allocative functions, there has been surprisingly little attention devoted to studying the ways in which asset markets collectively interact from a general equilibrium perspective.6 Furthermore, previous work does not address how the role of monetary policy depends on the extent of financial market development.We attempt to fill this gap by developing a monetary growth model that incorporates money, bank deposits, and equity.7 As in Schreft and Smith (1998), spatial separation and limited communication create a role for money and commercial banks. In our economy, young individuals are subject to random relocation shocks. As money is the only asset that can cross locations, relocated agents must liquidate all their asset holdings into currency. Thus, random relocation is analogous to the liquidity preference shocks in Diamond and Dybvig (1983). As a result, our model illustrates the risk-pooling role of financial intermediaries.In contrast to banks, we consider that the stock market promotes economic development by establishing a market in which capital can be transferred across time. For example, this may reflect specialization of factor inputs. To illustrate such ideas, we consider the following motivation. Individuals in the economy have specialized production technologies. …