ABSTRACT
The Blanchard (1981) model of real…“nancialinteraction provides one of the paradigm models of interaction between real and “nancial markets. As already discussed the model reformulates Keynesian IS…LManalysis from the perspective of a richer array of “nancial assets, namely long-term bonds and equities besides the usual presence of money and short-term bonds of (or textbook presentations of) the IS…LMmodel.1 The basic change in Blanchard•s extension of the IS…LM approach is that investment demand (and consumption demand) now depend on Tobin•s average q in the place of the real rate of interest. As a consequence, share price dynamics (but not yet long-term bond price dynamics)2 feed back into the real sector, thereby creating one of the links for real…“nancialinteraction. The conventional LM schedule or money market equilibrium of this approach, which as usual is dependent on real output and income, in turn provides the channel back from real to “nancial markets. The share price dynamics is determined by assuming a situation of perfect substitution and perfect foresight with respect to the interest-bearing assets.
