Output, the Stock Market, and Interest Rates

By OLIVIER J. BLANCHARD*

This paper develops a simple model of thedetermination of output, the stock marketand the term structure of interest rates. Themodel is an extension of the IS-LM modeland borrows from it the assumption thatoutput is determined by aggregate demandand that the price level can only adjust overtime to its equilibrium value. However,whereas the IS-LM emphasizes the interac-tion between "the interest rate" and output,this model emphasizes the interaction be-tween asset values and output. Asset values,rather than the interest rate, are the maindeterminants of aggregate demand and out-put. Current and anticipated output and in-come are in turn the main determinants ofasset values. It is this interaction that themodel intends to capture; its goal is tocharacterize the joint response of assetvalues and output to changes in the environ-ment, such as changes or announcement ofchanges in monetary and fiscal policy. Asthe above brief description makes clear, an-ticipations are central to the story; the as-sumption made in this paper will be one ofrational expectations.

The paper is organized as follows. SectionI describes the model, and Sections II-IVcharacterize the behavior of the economyunder the extreme but convenient assump-tion that prices are fixed forever. Sections Vand VI extend the analysis to the case whereprices adjust over time to their equilibriumvalue.

I. The Model

Let us assume that the economy is closedand that the physical capital stock is con-stant. There is one good and four market-able assets. These are shares which are titlesto the physical capital, private short- and

•Harvard University. I thank Rudiger Dombuschand Larry Summers for useful discussions. Financialassistance from the Alfred P. Sloan Foundation isgratefully acknowledged.

long-term bonds issued and held by individ-uals, and outside money.

A. Equilibrium in the Goods Market

We shall assume that there are three maindeterminants of spending. The first is thevalue of shares in the stock market—thestock market for short; being part of wealth,it affects consumption; determining thevalue of capital in place relative to its re-placement cost, it affects investment' (seeJames Tobin). The second is current incomewhich may affect spending independently ofwealth if consumers or firms are liquidityconstrained. The third is fiscal policy, boththrough public spending and taxes; fiscalpolicy will be summarized by an index ratherthan by an explicit treatment of both taxesand spending. A change in the index may bethought of as a balanced budget change inpublic spending. Total spending is expressedas

All variables are real, d denotes spending, qis the stock market value, y is income, and gis the index of fiscal policy.

Output adjusts to spending over time:

0 > O(1)

where a dot denotes a time derivative.There are two interpretations of (1), lead-

ing to the same functional form. The first isthe one given implicitly above which as-sumes that inventories are decumulated after

' A more detailed specification of aggregate demandwould distinguish between the average value of capitalwhich affects consumption and the marginal valuewhich determines investment. It would also possiblyintroduce human wealth and outside money as othercomponents of wealth.

132

VOL. 71 NO. I BLANCHARD: OUTPUT AND INTEREST RATES

an increase in aggregate demand until pro-duction is increased to meet demand.^ Thesecond is that spending is always equal toproduction but that actual spending adjustsslowly to desired spending d. The first em-phasizes the costs of adjusting production,the second the slow adjustment of spending.The interpretations are not mutually exclu-sive.

B. Equilibrium in the Assets Markets

The three nonmoney assets are assumedto be perfect substitutes. Hence arbitragebetween them implies that they have thesame expected short-term rate of return,^Their common expected rate of return mustin tum be such that agents are satisfied withthe proportion of money in their portfolios.

Portfolio balance is characterized by aconventional LM relation in inverse form:

(2) OO;

where / denotes the short-term nominal rate,y denotes income, and m and p denote thelogarithms of nominal money and the pricelevel. The short-term real rate is defined as

(3) = i-p*

An asterisk denotes an expectation; p* is theexpected rate of inflation.

L Arbitrage between Short- and Long-TermBonds

The long-term bonds are consols withyield / and price \/L The expected short-term nominal rate of retum from holdingconsols is therefore

It is the sum of the yield and the expectednominal capital gain. Arbitrage between

^A more satisfactory—and more complex— formu-lation would allow for inventories to be rebuilt laterduring the adjustment process.

' I use "short term" instead of "instantaneous" whichis more proper but also more cumbersome.

short and long bonds implies*

(4) /-/*//=/

or equivalently i*/I=I — i. If the long-termrate / is above the short-term rate /, agentsmust be expecting a capital loss on consols,that is, an increase in the long-term rate. LetR be the long-term real rate. Then by anequation similar to (4), we can define itimplicitly by

2. Arbitrage between Short-Term Bonds andShares

As q is the real value of the stock market,the expected real rate of retum on holdingshares is q*fq + ir/q, where IT denotes realprofit. Real profit is in turn assumed to bean increasing function of output:

a, >0

Arbitrage between short-term bonds andshares therefore implies

(6)q* ^

Equations (l)-(6) characterize output, thestock market and interest rates as functionsof policy variables m and g, expectations q*and/j*, and the price level p. The system isrecursive: long rates are determined byequations (4) and (5) but do not in tumdetermine other variables. Following Tobin,the only link between assets and goodsmarkets is the value of the stock market, q.To close the model, assume that expecta-tions are formed rationally. This leaves uswith the need for only one equation, theequation describing the behavior of the pricelevel.

n. Steady State and Dynamics with Fixed Prices

We start with the assumption that pricesare fixed. Hence, there is no actual and noexpected inflation; nominal and real rates

^Tbe implicit assumption is that agents hold theirexpectations with subjective certainty. If this was notthe case, the arbitrage equations would have to payattention to Jensen's inequality.

134 THE AMERICAN ECONOMIC REVIEW

A. Bod News B. Good News

MARCH 19S1

y"O(IS)

q"=0

y"O{lS)

FIGURE 1

are identical and the system simplifies to

(1) y^

(2') = cy-h{m-p)

Sl =r

The real interest rate replaces the nominalrate in (2). It is no longer an expected rateand is now denoted by r rather than r*. Theterm-structure relation is given by (5).

A. Steady State

In steady state ̂ ^ = 0, output equals spend-ing which is given by

1

Output depends on the stock market andfiscal policy. (Recall that we do not allowprices to adjust and that, in this "steadystate," output is demand determined, an as-sumption that we shall want to relax later.)From (2') and (6'), if q=q* = O:

q'• cy — h{m—p)

The stock market is the ratio of steady-stateprofit to the steady-state interest rate. Bothprofit and interest are increasing functions

of output: output increases profit directly; italso increases the transaction demand formoney and the interest rate. The effect ofoutput on the stock market is thereforeambiguous and two cases have to be consid-ered:

Let q denote the steady-state value of q.Then if {cq-ay)>Q, then the interest rateeffect will dominate and an increase in out-put will have the net effect of decreasing thestock market. For lack of a better term, thiscase will be called the bad news case. Theother will be called the good news case.

The loci y = ̂ and ^* = 0 are drawn inFigure I; the steady state is characterizedgraphically in each of the two cases.'

B. Dynamics

In the absence of changes in current orfuture policies, the assumption of rationalexpectations imphes that q* = q. Thus thedynamic behavior of the economy is char-acterized by two differential equations in q

'In the good news case, the existence of an equi-librium where the (9-O) tocus intersects the IS fromabove foUows from

lim ^ - 0

There might however be two equilibria. The other onehowever has both undesirable comparative statics anddynamic properties.

VOL. 71 NO. 1 BLANCHARD: OUTPUT AND INTEREST RATES

A- Bod News B. Good News

q

135

<l -

time

FIGURE 2. THE EFFECTS OF AN UNANTICIPATED MONETARY EXPANSION

and y. Trajectories corresponding to theseequations of motion are drawn in Figure 1.In each case, the steady state is a saddle-point equilibrium. (Algebraic proofs and de-rivations are given in Appendix A.) Giventhe value of _y which is given at any momentof time, there is a unique value of q which issuch that the economy converges to itssteady state. Following a standard if notentirely convincing practice,* I shall assumethat q always adjusts so as to leave theeconomy on the stable path to equilibrium.

m. A Monetary Expansion under Fixed Prices

What are the effects of an increase inmoney? The "steady-state" effects are clear:output and the stock market are higher inthe new equilibrium. The higher money stocklowers the real interest rate and thus thecost of capital. This lower cost leads to a

*S©e my 1979 paper for further discussion.

higher stock market value, higher spending,higher output and profit. These comparativestatics are very similar to the usual IS-LM.The dynamic adjustment is of more interest.To characterize it we need to distinguishbetween the case where the monetary ex-pansion is unanticipated (i.e., announcedand implemented simultaneously) and thecase where it is anticipated (i.e., known forsome time before its implementation).

A. An Unanticipated MonetaryExpansion

The dynamic adjustment path is char-acterized in Figure 2 (for the system lin-earized around its initial steady state). It isdrawn under the assumption that the econ-omy is initially in steady state EQ, The stockmarket jumps to A and the economy con-verges to £"1 over time. The behavior ofinterest rates, which cannot be read off thephase diagram, is plotted below.

THE AMERICAN ECONOMIC REVIEW MARCH 1981

When the increase in money takes place,output is given and it is the short-term ratewhich falls to maintain portfolio balance.To understand why the stock market jumps,we can integrate forward the arbitrage equa-tion (6) (taking into account the transversal-ity condition imposed by the requirementthat the economy converges). This gives q asthe present discounted value of profits;

9l =

The jump is then easily understood by look-ing forward at the adjustment path: interestrates are anticipated to be lower than beforeand profits are anticipated to be higher.What happens to the long rate? Althoughthe short-term rate initially falls, the expec-tation of increasing output leads to an ex-pected increase in the demand for moneyand thus to an expected increase in theshort rate: the long-term rate falls, but byless than the short; the term structure slopesupwards after the increase in money. Overtime, production increases in response tospending. What happens to the stock mar-ket? As time passes, the initial low discountrates and low profits disappear from theintegral and are "replaced" by higher dis-count rates and profits. In the bad newscase, the discount rate effect dominates: thestock market initially overshoots its steady-state value and decreases thereafter. In thiscase consol prices and shares have a similarqualitative behavior. The opposite holds inthe good news case: after their initial in-crease consol prices and shares move inopposite directions.

Note that the initial jump in the stockmarket is unanticipated, but that its move-ment afterwards is anticipated. This move-ment is in no way inconsistent either withrational expectations or the assumption ofno excess retum on shares. In this particularcase, rational expectations for the stockmarket tum out to be regressive (see Ap-pendix A). If ^, denotes the new steady-statevalue of q, we get

This result is however not very general andwill not hold below.

B. An Anticipated Monetary Expansion

Suppose that the monetary expansion isannounced at time t^ to take place at timet| >tQ. The steady-state effects are the sameas before, but the dynamic adjustment isdifferent. It is characterized in Figure 3.

Technically, the adjustment path isuniquely determined by the following re-quirements. At time t,, the economy, if it isto converge, must be somewhere on thestable arm of the postmonetary expansionsystem SS'. At time t^, output y is given.Between to and t, the system must satisfythe equations of motion on the premonetaryexpansion system. There is a unique trajec-tory which satisfies all these requirements;which one it is depends on the length of theperiod between tp and tj. (Charles Wilsongives a more detailed explanation and theassociated algebra in a model with a similarstructure.) The curve AB' corresponds to agiven period ( t | - t o ) , A"B" to a longerperiod.

The announcement of the monetary ex-pansion is itself expansionary. The stockmarket jumps at time t^ in anticipation oflower interest rates and higher profits aftertime t,. This increases spending and outputover time.

Between the announcement and the im-plementation, output increases. As themoney stock is still constant, the short-termrate also increases. Because of anticipatedlower short rates after t,, however, the long-term rate declines. Tlius the term structure"twists"; long and short rates moving inopposite directions. As the period of lowerrates comes closer, the stock market in-creases. Whether or not it overshoots itssteady state depends again on whether weare in the bad news or good news case.

At the time of the implementation, theshort-term rate falls to maintain portfoliobalance. Little else happens; the long-termrate and the stock market do not jump. Ifthey did, this would imply anticipated in-finite rates of capital gain or loss. After theimplementation, the behavior of the econ-omy is quahtatively similar to the case of anunanticipated increase.

Between to and t,, the movements in out-put, stock market, and interest rates happen

VOL. 71 NO. I BLANCHARD: OUTPUT AND INTEREST RATES

A. Bad News B. Good News

R,r

time

FIGURE 3. THE EFFECTS OF AN ANTICIPATED MONETARY EXPANSION

without apparent changes in policy. An out-side observer, unaware of the announce-ment, may indeed conclude from an ex-amination of the behavior of q and y overtime, that an initial "speculative" boom inthe stock market is the "cause" of the in-crease in output, and that the subsequentincrease in money takes place to reduce thepressure on interest rates.

IV. A Fiscal Expansion under Fixed Ihices

What are the effects of a fiscal expansion?The steady-state effects are again familiar:the fiscal expansion increases output, profit,and the interest rate. Hence, the effect onthe stock market is ambiguous; the stockmarket decreases in the bad news case, in-creases in the other.

Turning to the dynamics, I shall directlyconsider the effect of an anticipated fiscal

expansion, say, announced at tg to be imple-mented at time t,. It is indeed probably thecase that most changes in fiscal policy areknown before they are implemented. (Thecase of an unanticipated change is justthe limit of this case as t, tends to IQ.) Theadjustment is characterized in Figure 4.

There are now important differences be-tween the bad and good news cases. In thebad news case, the policy change is badnews for the stock market which falls atthe time of announcement. The reasonlies in the anticipated increase in the se-quence of short-term rates after the policy isimplemented. In this case, it more thancompensates the anticipated increase in thesequence of profits. Between the announce-ment and the implementation, fiscal policyhas a perverse effect on output: because ofthe decrease in the stock market, privatespending decreases and public spending is

138 THE AMERICAN ECONOMIC REVIEW

A. Bad News B. Good News

MARCH 1981

1, time'0 '1 'ima IQ 1,

FIGURE 4. THE EFFECTS OF AN ANTICIPATED FISCAL EXPANSION

time

unchanged. Output therefore decreases untiltime I,, and so does the short-term rate. Thelong-term rate, however, increases in antic-ipation of higher short rates in the future. Atthe announcement, the term structure is up-ward sloping and twists during the periodbetween announcement and implementa-tion.

At and after the implementation, publicspending increases, and so does output overtime. The short-term rate increases with out-put; the term structure remains positivelysloped, its slope decreasing as the economyreaches its new steady state. The stockmarket and consol prices have, in this case,the same qualitative behavior.

There is no perverse effect of the an-nouncement of a change in policy in thegood news case. The anticipation of higherprofits more than offsets the anticipation ofhigher rates and the stock market increases.This jump and subsequent increase in the

stock market leads to an increase in output,and the long-term rate jumps in anticipationof higher short rates; the term structure isupward sloping. At the time of the imple-mentation, the only noticeable effect is alarger rate of increase of output. An outsideobserver might again conclude that thepolicy change was not necessary, as theeconomy was already expanding. Note fi-nally that, in this case, consol prices and thestock market move in opposite directions.

V. A Monetary Expansion under FlexlUe Prices

There is an uneasy feeling in characteriz-ing the effects of nominal money over timeassuming prices constant. I shall relax thisassumption, at the cost of some additionalcomplexity, and show how this affects theresults obtained above. The discussion willbe limited to characterizations of monetarypolicy.

VOL. 71 NO. I BLANCHARD: OUTPUT AND INTEREST RATES 139

If prices were perfectly flexible, changes givesin the level of money would be neutral,leaving output and the stock market unaf-fected. The dynamic adjustment of nominalvatiables could be characterized using thismodel (this would extend the analysis ofThomas Sargent and Neil Wallace) butwould not be of considerable interest. Wewant instead to allow for movements inoutput, at least temporatily. The simplestprice adjustment is probably

*= i-p* = cy~

where \p does not depend directly on p. Ahigher value ofp leads to a higher r* throughthe real balance effect (h) and the Mundelleffect (9).

Linearizing the system around its steadystate gives

(7)

where p is the price level associated withfull-employment output y and the level ofnominal money m. This adjustment processimplies that money is neutral in the long runas prices adjust to their equilibrium valueover time; it also assumes that the reasonfor the slow adjustment of ptices is notirrational expectations, as/j=/j*, but inertiaor the existence of predetermined nominalcontracts. The extension of equation (7) toinclude an unemployment term such as (>*-y) would make (7) look more like a Phillipscurve. But it would make the analysis morecumbersome and not affect results substan-tially.

A. Steady State and Dynamics

(8)

r cq-ay {h-\-9)qaa —ab 00 0 -9

y-yp-p

(9) q-q=-

From equations (I)-(7), steady-state out-put, interest rates, and the stock marketare invariant to nominal money. Nominalmoney simply affects prices proportionately.

To understand how (7) affects the dy-namics, consider an (unanticipated) increasein nominal money. When this expansiontakes place, real balances are higher as pricescannot instantaneously adjust, decreasingthe noniinal interest rate. Prices are, how-ever, now expected to increase and theexpected rate of inflation decreases the real -̂ \iab-rate of interest given the nominal rate; thiseffect is usually referred to as the "Mundelleffect." Both effects work in the same direc- (^0) y-y= -tion, decreasing the real rate. Over time, realbalances decrease and the expected inflationbecomes smaller; both effects work again in x [the same direction, now increasing the realrate. Algebraically, using (2), (3) and (7) (II) p-p=-i

This system has three roots. Because of itsrecursive structure, two of the roots are thesame as in the fixed-price case, /i<0 and^>0. The third is simply -9, the (negativeof) the speed of adjustment of ptices.

One root, i, is positive. Two variables yand/7 cannot "jump." Thus the initial condi-tions for {y,p) together with the require-ment that the system converges to steadystate determines a unique trajectory and, asin Sections II-IV, a unique value for q.

B. An Unanticipated Monetary Expansion

Consider an unanticipated monetary ex-pansion dm at time tj, =0. If we assume theeconomy to be in steady state before thechange, the behavior of output, prices andthe stock market is given by (see AppendixB)

9+h

140

q.y

THE AMERICAN ECONOMIC REVIEW

R.r

MARCH 1981

to=O time to=0 time

FIGURE 5. THE EFFECTS OF AN UNANTICIPATED MONETARY EXPANSION

UNDER FLEXIBLE PRICES

(These relations hold only if ff^-[i. TheAppendix gives the relations for 9= -ju.) Ifthere was no Mundell effect (i.e., if, forexample, money balances paid the expectedrate of inflation), the relations defining qand y would have h rather than (9-\-h) inthe numerator. The roots 9, fi, ^ would beunaffected.

The first question is whether the analysisof Sections II-IV is the limit of the flexibleprice case when prices adjust extremelyslowly, that is, as 9 tends to zero. As shownin the Appendix, this is indeed the case.Thus the dynamics of Sections II-IV are"approximately correct" if prices adjustslowly.

The second question is how price flexibil-ity affects the impact effect of monetarypolicy. Intuition suggests the elements of theanswer: Assume that there is no Mundelleffect; money balances pay the expectedrate of inflation. Then the more flexibleprices are, the faster the real money stockwill return to its previous level. This in tumsuggests a faster return of profits and realinterest rates to their previous levels, thus asmaller initial jump in the stock market.This in turn implies a lower initial increasein spending and a lower rate of increase ofoutput.

The countervailing effect of more flexibleprices is through the Mundell effect. Themore flexible prices are, the higher the ini-tial rate of inflation and, ceteris paribus, thelower the real rate of interest. This lower

initial sequence of real interest rates tends toincrease the initial jump in the stock market,leading to a higher initial rate of increase inoutput.

Evaluating (9) at t = 0 gives

/ - u 9-\-h_ ,

As 9, h, and ^ are positive, a monetaryexpansion always increases the stock marketand spending. The effect of an increase in 9is indeed ambiguous. With no Mundell ef-fect, the numerator would simply be h: inthis case more flexible prices lead to asmaller impact effect. The Mundell effectworks in the opposite direction; the net ef-fect depends on {h-i). The positive root ^of the system does not depend on h. Thusthere are no restrictions on the sign of (/i —

What can we deduce about the adjust-ment path from equations (9)-(lI)? Themonetary expansion leads to an expansionof output over time followed by a return tosteady state; output remains above its equi-Ubrium value during the period of adjust-ment. The real interest rate increases rapidlyafter its initial decline, overshooting its equi-librium value. This is due partly to lowerreal money balances, partly to higher trans-action demand for money, and partly tolower expected inflation. As a result, thelong-term real rate initially declines by lessthan the short rate; the term structure is

VOL. 71 NO. I BIANCHARD: OUTPUT AND INTEREST RATES 141

initially upward sloping, flattening over timeto become downward sloping. TTie se-quences of initially increasing profits andinterest rates followed by decreasing profitsand interest rates have a complex effect onthe stock market which may keep increasingafter its initial jump and which may alsodecrease below its steady-state value duringthe adjustment process. These results arederived in Appendix B and summarizedgraphically in Figure 5.

VI. Summary and Extensions

This paper has shown the interaction be-tween output and the stock market. Theeffect of a change either in current or antic-ipated policy is a discrete change in thestock market due to the change in the antic-ipated sequence of profits and real interestrates. This, in turn, together with the changein policy, affects spending and output overtime, validating the initial anticipations ofprofits and interest rates. The stock marketis not the "cause" of the increase in output,no more than the increase in output is thecause of the initial stock market change.They are both the results of changes inpolicy.

Whether policies are anticipated or not isimportant; the announcement itself will usu-ally lead to a change in anticipated profitsand discount rates, leading to a change inthe stock market. Although in this case thechange in the stock market and the resultingincrease in output will precede the change inpohcy, they are still caused by it; the imple-mentation of the policy may have little ap-parent effect. Under plausible assumptions,the announcement of an expansionary fiscalpohcy may have a perverse effect, decreas-ing output before the actual implementationof the policy.

The effect of more flexible prices is todecrease the overall effect of changes innominal money. The effect on the initialimpact of changes in money is, however,ambiguous: the smaller overall effect leadsto a smaller change in the stock market, butthe faster initial infiation may lead to lowerreal interest rates initially, and to a largerinitial change in the stock market.

There are at least two logical extensionsof this model. The first is a more detailedtreatment of aggregate demand, allowing inparticular a more detailed treatment of fis-cal policy. This is done in a medium-sizedeconometric model (see my 1980 paper) andparallels a similar attempt by Ray Fair. Thesecond is a more detailed treatment of ag-gregate supply: the implicit assumption ofthis paper is that the economy is inKeynesian unemployment, with no effectsof the real wage. Allowing for an effect ofthe real wage and taking explicit account ofcapital accumulation are the next items onthe agenda.

APPENDIX A: THE FIXED-PRICE CASE

The system composed of (1), (2'), and (6')is linearized around its steady state:

r

aa abq-qy-y

The assumption that the IS intersects theLM from below implies that the determi-nant of the above Jacobian is negative. Thesystem has two roots of opposite sign, ju<0and ^ > 0 . The characteristic vector associ-ated with /x, (xpXj) is such that

(Al) - i =fi-r

ab+ Haa

The equations of motion along the stablearm are thus given by

(A2)

where c, depends on the initial conditionsfor>'. Thus, along the stable arm:

(A3) ^ay

An increase in nominal money, dm, in-creases steady state q and y. Denoting their

142 THE AMERICAN ECONOMIC REVIEW MARCH 1981

new steady-state values by (?, and>',, we get

(A4) (q^-q)=-2m,^

At the time of the increase, t = 0,;' is fixed:

This gives, replacing c, in (A2)

Or, using (A4)

(A5) (? — )̂ =qh

APPENDIX B; THE FLEXIBLE PRICE CASE

The characteristic polynomial of the ma-trix in (8) has three roots. Two are the sameas in the fixed-price case, in<0 and ^>O.The last is -e<0.

The vectors associated with the negativeroots fi and (-9) are, respectively (up to afactor of proportionality), if fi¥= -9

[ab + fi aa 0]

and ab — 9 aa

The stable trajectory therefore satisfies

(A6) q-q=.

(A7) y-y = .

(A8)

The variables c,, Cj are determined by initialconditions for y and p. An increase in dmleaves y, q unchanged and increases p bydm. So after an unanticipated increase dm atto = 0, p-p~-dm and y-y=.Q, This de-termines uniquely c, and Cj using (A7) and(A8) at to =0. Replacing these values of c,and c^ in (A6) to (A8) gives equations (9)-(II) in the text. Note that if tf = O, (9) re-duces to equation (A5).

For the case where fi=-O, L'Hospital'srule can be used on (9) and (10) to derive(y-y) and (q-q). This gives

-iy\e^' dm

We may now characterize the dynamicbehavior of q. The initial jump in ^ at t = 0is given by

As iq — q) is the sum of two declining ex-ponentials, it has for t > 0 at most one inter-ior maximum or minimum. If such an ex-tremum exists, it happens at t* given by

9 ab-9

9=

The initial rate of change of q is given by

x[-9(ab-9)-ii(ab+n)]qdm

Thus, for ^|,_o >0, a necessary condition isthat ab + pi>0, or equivalently c^—a, <O:the good news condition is necessary butnot sufficient anymore.

VOL. 71 NO. I BLANCHARD: OUTPUT AND INTEREST RATES 143

The satne analysis is easily done for y.The variable y increases initially, reaches itsmaximum for:

It decreases to steady state after that. Thebehavior of the short-term real rate is di-rectly obtained from

REFERENCES

O. BUndiard, "Backward and Forward Solu-tions for Economies with Rational Expec-tations," Amer. Econ. Rev. Proc, May1979,69, 114--18.

, "The Monetary Mechanism in theLight of Rational Expectations," in Stan-ley Fischer, ed., Rational Expectations andEconomic Policy, Chicago 1980.

R. C. Fair, "An Analysis of a Macro-Econometric Model with Rational Expec-tations in the Bond and the StockMarket," Amer. Econ. Rev., Sept. 1979,69, 539-52.

L. Metzler, "Wealth, Savings and the Rate ofInterest," / . Polit. Econ., Apr. 1951, 59,93-116.

T. Sargent and N. Wallace, "The Stability ofModels of Money and Growth with Per-fect Foresight," Econometrica, Nov. 1973,41, 1043-48.

J. Tobin, "Monetary Pohcies and the Econ-omy: The Transmission Mechanism,"Southern Econ. J., Jan. 1978, 44, 421-31.

C. Wilson, "Anticipated Shocks and Ex-change Rate Dynamics," J. Polit. Econ.,June 1979, 87, 639-47.