It bugs me when people forget Tobin's q. It's not as though James Tobin was some sort of wild-eyed fringe monetarist. He was a very mainstream Keynesian economist. Ben Bernanke missed an opportunity to invoke the effect of stock prices on Tobin's q and hence on investment as part of his explanation of why loosening monetary policy will work.

Tobin's q is the ratio of the market value of a firm's assets, as measured by its stock and bond prices, divided by the replacement cost of those same assets. It's the value of the bulldozers when they are owned by the firm divided by the cost of buying those same bulldozers. That "average q" is a proxy for the "marginal q", which is what really matters for investment decisions. If buying one extra bulldozer adds more to the financial value of the firm than it costs the firm to buy it, then the firm will increase its stock price by buying the extra bulldozer. And so it should buy the extra bulldozer.

According to James Tobin, one of the main channels of the monetary policy transmission mechanism was through q. Loosening monetary policy would raise stock and bond prices and so raise q and so increase the demand for new investment goods.

Firms can finance new investment by issuing bonds or by issuing stocks. Or by reinvesting earnings on behalf of the stockholders, which is just a shortcut way of issuing new stocks and selling them to the existing stockholders in exchange for those retained earnings, followed by a reverse stock split to keep the number of stocks constant.

If an increased demand for corporate bonds causes bond prices to rise, it makes it cheaper for firms to finance new investment. If an increased demand for stocks causes stock prices to rise, it makes it cheaper for firms to finance new investment. There's an exact parallel between the effect of bond prices and stock prices on investment. If we say that a rise in corporate bond prices caused by monetary loosening will encourage investment, we should also say that a rise in stock prices caused by monetary loosening will encourage investment.

Ben Bernanke talked about the effect of higher bond prices (lower corporate bond rates) encouraging investment. But the only role he gave to higher stock prices was some measly wealth effect and effect on (consumer?) confidence. It almost reads like an afterthought. Stock prices aren't a bit player. They are one of the main actors. What about the effect of higher stock prices on investment? Don't forget Tobin's q!

"This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion." (my emphasis).

But I'm so glad to see him invoke the virtuous circle of the multiplier in that last sentence.