S&P 500 under Dynamic Gordon Model

In this paper, we extend the Dynamic Gordon Model (Campbell and Shiller, 1988) with a semistructural, medium-term macroeconomic model. The proposed framework allows us to analyze the relationship between output gap, inflation, stock prices, and interest rate as in Blanchard (1981). We estimate the model using Bayesian techniques on quarterly data from 1984 to 2006. The decomposition of the unconditional variance of the variables shows that (i) demand shocks are relevant for both macroeconomic variables and stock prices; (ii) supply and interest rate shocks affect, to a lesser extent, inflation and interest rates, respectively; and (iii) shocks to the pricedividend ratio account for around 30% of the variability of the output gap, inflation, and interest rates, reflecting in this manner the importance of stock prices on the dynamics of macroeconomic variables.