Sentiment: The bridge between financial markets and macroeconomy

This paper develops a parsimonious model by incorporating a boundedly rational agent-based model from the finance literature into the macroeconomic framework. An empirical investigation using US data shows that firm investment depends on sentiment and interest rate, while sentiment and short-term interest rate are influenced by the stock market. The stock market is subject to the influences of firm performance as well as the sentiment. It is found that sentiment serves as a bridge connecting the macroeconomy and the stock market. On the one hand, the macroeconomy influences the stock market through sentiment as sentiment affects the derived fundamental value of the stock market. On the other hand, the stock market has an indirect influence on the macroeconomy in terms of investment and capital stock through its impact on sentiment and interest rate.