This section then turns to the empirical literature, analysing the linkages between asset prices, especially equity and house prices, and real variables. Empirical studies support many of the predictions of standard models with respect to linkages between asset prices and macroeconomic outcomes. First, movements in asset prices are associated with changes in investment and consumption that are broadly consistent with the predictions of many standard models. In particular, studies that use microeconomic data support various theoretical predictions regarding the impact of asset prices on household and firm behaviour. Second, asset prices appear to play a “signalling role” as they tend to comove with (or lead) various measures of current and future activity.

Although the basic models provide helpful guidance, a number of puzzles remain, particularly with respect to inconsistencies between the predictions of models and the data. First, asset prices are much more volatile than fundamentals would imply. They can at times deviate substantially, or at least appear to, from predicted values based on fundamentals. Second, there are many questions about the quantitative importance of the linkages between asset prices and macroeconomic aggregates. The strength of these empirical linkages appears to depend on various factors. Investment and consumption, for example, respond differently to changes in asset prices than standard models would predict, with a significant role for nonprice factors in influencing agents’ behaviour. Third, there are limits to the predictive power of asset prices for economic activity. Empirical evidence also suggests that the channels leading to the predictive power of prices may be different from those suggested by the basic models.

Section 3 briefly reviews the international dimensions of linkages between asset prices and macroeconomic outcomes. Given the extent of cross-border integration of real and financial markets today, any discussion of the linkages between asset prices and activity has to take into account the international dimensions. Like their closed economy counterparts, however, many of the international asset pricing models are based on partial equilibrium analysis. Moreover, these models often do not consider whether international asset holdings are consistent with observed prices. While recent theoretical studies have taken significant steps to remedy these shortcomings and analyse the dynamics of asset prices in richer, general equilibrium environments, there is a broad realisation that gaps remain.

Empirical studies find that certain asset prices tend to move together and emphasize the importance of common (global) shocks (factors) in explaining fluctuations in asset prices. This is a natural outcome of the major role that international financial integration has played in shaping asset price movements in recent decades. In addition, the empirical literature documents that domestic financial development and trade integration affect the degree of comovement of asset prices across countries. Even prices of non-tradable assets, such as real estate, tend to move together across countries, suggesting that there are indeed global factors driving asset price movements.

However, there are many puzzling aspects associated with the international dimensions of asset prices. First, international financial integration appears to amplify both the volatility and comovement of asset prices beyond what standard models would suggest. Second, the lack of international diversification of portfolio investment, the so-called home bias, has been hard to reconcile with the predictions of most asset pricing models. Moreover, the prices of internationally-traded assets continue to depend on local risk factors, suggesting some de facto segmentation of markets despite the removal of many barriers to cross-border trading (especially of equities).

Section 4 starts with a brief review of the determinants of exchange rates. The theoretical literature on exchange rate determination has gone through several phases, from basic arbitrage-related models to fully fledged general equilibrium models. These models point to 3