There has been long determined and interest on the role of banks in the transmission of monetary policy and business cycle. For example, Keynes (1936) found that money plays an important role to economic growth. Furthermore, Gurley and Shaw (1995) began to redirect attention toward the overall interaction between financial structure and real activity, emphasizing financial intermediation, and particularly the role of financial intermediaries in the credit supply process as opposed to the money supply process.
However, Bernanke and Blinder (1988) produced another view that looked into the assets side as a monetary policy channel to influence the economic activities. For example, in a monetary contraction, banks’ reserves decrease because of reserve requirements and hence reduce the deposits. Consequently, it may increase the short-term and long-term interest rate and also reduce the supply of bank loans. If bank-dependent borrowers are dominant, thus it will reduce the investments and thereby in economic activity. This view, known as balance sheet channel, is further argued by Bernanke and Gertler (1989). They claim that monetary policy can also affect a borrower’s financial position or net worth, thereby influencing the costs of external finance to the borrower (arising from the loss of creditworthiness). Consequently, the monetary policy can affect the borrowers’ investment and spending plan.
In this paper we provide new evidence that relates asset prices, consumption volatility and expected growth. In particular, we show that economic uncertainty (that is, consumption volatility) sharply predicts and is predicted by asset valuation ratios. Our evidence shows that a rise in economic uncertainty leads to a fall in asset prices, and that high valuation ratios predict low subsequent economic uncertainty. In addition, we show that there is a strong positive relation between aggregate earnings growth and asset prices. In all, our evidence suggests that fluctuations in economic uncertainty and expected growth are potentially important channels for interpreting asset markets and the variation in asset prices.
Why is this evidence important? First, this empirical evidence highlights an often discussed but not verified view that aggregate economic uncertainty (i.e., real aggregate consumption volatility) has sizable effects on asset valuations and that financial markets dislike economic uncertainty. Our empirical work for the U.S. and foreign economies suggests that the effects of fluctuating economic uncertainty on asset valuations are sizable. Second, the evidence regarding growth rates suggests that fluctuations in expected growth directly affect asset valuations and information regarding future expected growth is encoded in current asset valuations. Our overall evidence regarding economic uncertainty and expected growth suggests that a plausible interpretation of asset markets is based on these economic fundamentals. A rise in economic uncertainty increases expected returns and leads to a fall in asset valuations. A rise in expected growth, on the other hand leads to a rise in asset valuations. Both these effects can be interpreted from the perspective of general equilibrium models (see for example, Bansal and Yaron (2004)).
The point of departure for all modern research on capital structure is the Modigliani-Miller (M&M, 1958) proposition that in a frictionless world of full information and complete markets, a firm's capital structure can not affect its value. This proposition contrasts sharply with the intuitive notion that a firm with risk-free debt could borrow at an interest rate below the required return on equity, reducing its weighted average cost of financing and increasing its value by substituting debt for equity. But the powerful arbitrage arguments employed by M&M demonstrate that market prices will compensate for any leverage decision by the firm.
