10 - Stock Prices and the Real Economy: Power-Law versus Exponential Distributions

Summary

This final chapter explores the relationship between stock prices and the real economy. The standard approach – the so-called consumption-based asset pricing model – attempts to explain it based on the assumption of the representative agent. In this chapter, we argue once again that the representative agent assumption is fundamentally flawed. Drawing on the recent advancement of “econophysics” on financial markets, we argue that in contrast to the neoclassical view, there is in fact a wedge between financial markets, the stock prices in particular, and the real economy.

Introduction

Stock prices depend necessarily on the real economy. Their “correct” prices or the fundamental values are the discounted present values of a stream of future dividends/profits. Because business activities, profits in particular, are significantly affected by the state of the real economy, the stock prices are also affected by the real economy. More precisely, in the standard neoclassical theory, stock prices are simultaneously determined with all the supplies and demands in general equilibrium (Diamond, 1967). Thus, like production and consumption, the stock prices depend ultimately on preferences and technologies.

However, there is a long tradition in economics which questions whether the stock prices are really determined in the way stated above. Many believe that “bubbles” are possible in the market. And whether or not they are “rational,” extraordinary changes in the stock prices (either up or down) by themselves may do harm to the real economy They are not a mere mirror image of the real economy.