RDP 2011-06: Does Equity Mispricing Influence Household and Firm Decisions? Appendix D: Alternative Identification Strategy

Rather than partitioning the system in Equation (9) according to those variables directly influenced by permanent and transitory shocks, I now partition the system into equity prices (y_22t) and other variables . That is,

where again I use six normalisation restrictions on the main diagonal of B₀. Using the same methodology as that discussed previously, it is straightforward to verify that provided exists, one can proceed estimating

using z_t as an instrument for Δy_22t. The estimated reduced-form residuals, comprising both permanent and transitory shocks , can then be used as instruments for in the estimation of

where I have used the conformable partition

The additional restriction that mispricing shocks have only transitory effects, , is not imposed.