Government financial policy and the return on financial assets

Robert J Levy, Purdue University

Abstract

This thesis consists of three separate essays on government financial policy and the returns on financial assets. The first essay is a contribution to a strand of literature which attempts to integrate capital market theory and monetary theory in order to better examine the effects of monetary policy on the pricing of financial assets. A multi-beta asset pricing relationship is derived in which money provides transaction services and serves as a portfolio asset, but also takes into account the risk associated with uncertain wealth effects from government open market policy and nominal interest rate fluctuations. A corresponding consumption-based asset pricing model is formulated and tested. Regression tests of this modified consumption-based pricing formula are performed for a variety of assets using data for the years 1931-1986 and various subperiods. These tests show that nominal interest rate risk adds significant explanatory power to the standard consumption-beta model of asset returns. Essay two seeks to provide a theoretical explanation for a set of stylized facts on the relationship between the variance in growth of the money supply and the volatility of interest rates and money demand. Using a stochastic version of a traditional money growth model it was found that the effects of variability in the growth of the money supply in this model are consistent with these stylized facts. This essay also finds that monetary policies which are not sufficiently sensitive to changes in interest rates are likely to result in higher expected interest rates and a higher variance of interest rates in the long term. Such policies may also lead to highly unstable interest rates. The model's predictions appear to be strongly consistent with monetary policy experience in the early 1980's. The last essay deals with the time consistency problem of exchange rate policy in an open economy. Earlier papers in this field have shown that fixed-exchange rate policies are usually not time consistent and hence infeasible, while flexible rate policies though feasible, may not be able to support an equilibrium with non-zero asset trade. The time consistency problem arises from an incentive for governments to redistribute world wealth from foreign to domestic residents when resident households change portfolio selections. This paper offers two solutions to that problem: (i) the establishment of a futures market in bonds and equities to permit households to settle portfolio adjustments in advance, and (ii) the use of trigger strategies by government agents in which retaliation is used to deter any attempt to redistribute wealth via surprise inflation or deflation. A sufficient condition is found for trigger strategies to support a non-zero asset trade equilibrium.

Degree

Ph.D.

Advisors

Carlson, Purdue University.

Subject Area

Economics

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