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Market Liquidity as a Sentiment Indicator*

Malcolm Baker
Harvard Business School
Jeremy C. Stein
Harvard Economics Department and NBER
First draft: October 2001
This draft: February 2002


We build a model that helps explain why increases in liquidity¾such as lower bid-ask
spreads, a lower price impact of trade, or higher share turnover¾predict lower
subsequent returns in both firm-level and aggregate data. The model features a class of
irrational investors, who underreact to the information contained in order flow, thereby
boosting liquidity. In the presence of short-sales constraints, unusually high liquidity is a
symptom of the fact that the market is currently dominated by these irrational investors,
and hence is overvalued. This theory can also explain how managers might successfully
time the market for seasoned equity offerings (SEOs), by simply following a rule of
thumb that involves issuing when the SEO market is particularly liquid. Empirically, we
find that: i) aggregate measures of equity issuance and share turnover are highly
correlated; yet ii) in a multiple regression, both have incremental predictive power for
future equal-weighted market returns.
(결론 부분만 참고)
The Great Depression as a Credit Boom Gone Wrong

Barry Eichengreen
University of California, Berkeley
Department of Economics
549 Evans Hall # 3880
Berkeley, Ca 94720-3880


Kris Mitchener
Santa Clara University

Revised, August 2003

The experience of the 1990s renewed economists’ interest in the role of credit in macroeconomic
fluctuations. The locus classicus of the credit-boom view of economic cycles is the expansion of
the 1920s and the Great Depression. In this paper we ask how well quantitative measures of the
credit boom phenomenon can explain the uneven expansion of the 1920s and the slump of the
1930s. We complement this macroeconomic analysis with three sectoral studies that shed
further light on the explanatory power of the credit boom interpretation: the property market,
consumer durables industries, and high-tech sectors. We conclude that the credit boom view
provides a useful perspective on both the boom of the 1920s and the subsequent slump. In
particular, it directs attention to the role played by the structure of the financial sector and the
interaction of finance and innovation. The credit boom and its ultimate impact were especially
pronounced where the organization and history of the financial sector led intermediaries to
compete aggressively in providing credit. And the impact on financial markets and the economy
was particularly evident in countries that saw the development of new network technologies with
commercial potential that in practice took considerable time to be realized. In addition, the
structure and management of the monetary regime mattered importantly. The procyclical
character of the foreign exchange component of global international reserves and the failure of
domestic monetary authorities to use stable policy rules to guide the more discretionary approach
to monetary management that replaced the more rigid rules-based gold standard of the earlier era
are key for explaining the developments in credit markets that helped to set the stage for the
Great Depression.

JEL classification codes: E3, N2.
When the Bubble Bursts:
Monetary Policy Rules and Foreign Exchange Market Behavior

Nicoletta Batini* and Edward Nelson**
October 2000
Preliminary and Incomplete
(Please do not quote without the authors’ permission)


We examine the effects of a “bubble” in the foreign exchange market, defined as an exogenous process that
temporarily shifts the exchange rate away from the value implied by fundamentals. The bubble process is
analogous to Bernanke and Gertler’s (1999) specification of an asset price bubble. We evaluate the
performance of alternative simple monetary policy rules under both bubble and no-bubble scenarios and
investigate whether policymakers should react to the deviation of the exchange rate from its steady-state
The policy experiments employ a small-scale forward-looking structural model calibrated to UK data,
which we previously used in Batini and Nelson (2000). For this model, which includes an uncovered
interest parity condition, we find that the appropriate response to the exchange rate is captured by the
expected inflation term, provided that the response coefficient and the inflation horizon are optimized.
When uncovered interest parity is relaxed, there appears to be more merit in incorporating a separate
exchange rate term in the monetary policy rule.
This chapter contains two essays on the
macroeconomic and financial aftereffects
of the bursting of an asset price
bubble. This issue is topical given the
large and persistent decline in equity prices
since 2000 and concerns that the fallout will
continue to be a drag on the recovery.

The first essay reviews the experience with
asset price busts in industrial countries in the
postwar period, seeking to draw out common
patterns in macroeconomic and financial developments.
The essay finds that equity price busts
occurred on average every 13 years, lasted for
2!/2 years, and were associated with GDP losses of
about 4 percent of GDP. Housing price busts
were less frequent, but lasted nearly twice as
long and were associated with output losses that
were twice as large, reflecting greater effects on
consumption and banking systems, which are
typically heavily exposed to real estate. Against
this background, the recent equity price bust
itself has been similar to earlier episodes in
terms of decline and duration. However, output
and investment growth have fallen more than
usual, likely reflecting higher-than-typical investment
growth before the bust. Another important
difference is that housing prices in a number of
countries have continued to increase throughout
the equity price bust, in many cases by more
than the threshold for a housing price boom.
This is a particular concern since housing booms
have been followed by busts about 40 percent of
the time, and have been associated with larger
output losses.

The second essay looks at the impact of equity
price busts on corporate financial health, and—
through that—on investment behavior. The
essay finds that equity price booms are generally
associated with a large increase in corporate
investment and borrowing, driven by buoyant
domestic demand, strong expected rates of
return, and strong cash flow. Once it becomes
clear that profitability will fall short of expectations
or that corporate financial health is in danger,
this process is reversed, as firms try to adjust
by retrenching their balance sheets and reducing
investment. The impact of the recent equity
price bust on corporate balance sheets has so far
been somewhat smaller than in the episodes of
the late 1980s and early 1990s—in part because
valuations have remained above historical levels,
sharply lower interest rates have helped shore up
corporate liquidity, and the boom was concentrated
in the information technology (IT) sector,
where low leverage helped mitigate spillovers to
the banking sector. However, corporate leverage
remains relatively high, and may continue to be
a drag on recovery for some time, particularly in
Europe where investment is largely financed
through bank borrowing rather than equity

Real and Financial Effects of Bursting

Asset Price Bubbles1

The long bull market and the exuberance
associated with the new economy boom of the
1990s came to a halt in 2000. Since then, broad
equity price indices in industrial countries have
fallen sharply and persistently. Asset price
crashes or busts have often been associated with
declines in economic activity, financial instability,
and, sometimes, large budgetary costs from the
recapitalization of banking systems. However,
while many countries have experienced economic
slowdowns after the most recent wave of
equity price busts, the downturns have not been
especially severe. Similarly, while equity prices


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