RDP 2011-06: Does Equity Mispricing Influence Household and Firm Decisions? 7. Conclusion

This paper proposes a new method for identifying the effects of equity market mispricing on household and firm decisions. The key assumptions used are that mispricing shocks only have transitory effects on the economy, and that there exist observable data that are correlated with these shocks, but are not correlated with perturbations to fundamentals.

The results highlighted in this paper are qualitatively consistent with the idea that equity price bubbles have the potential to distort household and firm decisions. Consumption does appear to increase with a lag in response to a positive mispricing shock, and there is evidence to suggest that firms may change the timing of dividend payments as a signal of their optimism concerning future investment opportunities. However, quantitatively, the results estimated here are not consistent with the idea that mispricing has highly distortionary effects on household and firm decisions. Overall, the effects estimated are statistically significant and modest. There is also evidence to suggest that households reduce their exposure to equity in the latter stages of an equity price bubble.

Taken together, these results suggest that the effects of equity market mispricing are neither trivial, nor as large as has sometimes been claimed in qualitative accounts of bubbles. On balance, they suggest that periods identified as bubbles should be taken into consideration by policy-makers to the extent that variables such as consumption may be growing at a rate which differs to that justified by fundamentals. However, they do not imply that policy-makers should necessarily seek to address distorted equity price signals. This is a broader question which requires consideration of the various costs and benefits associated with using different policy tools to address particular episodes of equity market mispricing.