The link between real and financial markets is a perennial source of debate and research in macro-finance. The issue resurfaces time and again in different forms: Does the functioning of financial systems have any effect on real activity (commodity market)? What is the possible relation between ‘financial’ claims and ‘real’ claims? These questions have gained tremendous currency once again after the subprime crisis and the recent ‘great recession’ in the Euro zone. The purpose of this paper is to analyze how the ‘virtual’ economy, captured through the stock market (because stock markets are an integral part of contemporary financial systems), interacts with the ‘real’ economy producing goods and services. The paper tries to critically understand the short-run interconnections between the expansion of aggregate demand through wealth effect generated by stock market and macroeconomic stability. The paper finds that in a dynamic IS-LM type model with wealth effect, there is a possibility of multiple equilibria and some of them are not stable. Given monetary authority’s emphasis on reducing financial market instability, a stabilization program exercised through monetary policy may fail to work when wealth effect is significant. Instead, redistribution of income through tax may turn out to be more effective.

The issue of the link between real and financial markets in macro-finance is an old topic but is not yet over. The issue resurfaces time and again in different forms: Does the functioning of financial systems have any effect on real activity (commodity market)? What is the possible relation between ‘financial’ claims and ‘real’ claims? These questions have gained tremendous currency once again after the subprime crisis and the recent ‘great recession’ in the Euro zone. Macroeconomics teaches us that financial and nominal variables have little effect on the economy in the long run under fully flexible prices. It is specially so if markets are competitive. This is argued through a ‘dichotomization’ of real and financial sides of the economy. Along perfect foresight path, financial variables will have no effect on real side even in the short run. The famous ‘separation’ principle of Modigliani and Miller—that financing and investment decisions are independent of each other—sometimes provides the rigorous justification to the researchers for abstracting from the complications induced by financial considerations. However, such a proposition may not be correct in the short run and further when there are frictions in transactions, a particular form of which is asymmetric information.

Applied Economics Journal, Analytical Perspectives, virtual, IS-LM, financial, great recession, dichotomization, Modigliani and Miller, Macroeconomics, teaches, Real-Financial Interaction.