Stock prices on North American stock markets have risen sharply in the 19905. For example, in 1998, the main index of the Toronto Stock Exchange, the TSE300 stood at 2.5 times its level in 1990 in real terms. Of course, the fall has been rather dramatic since. Some have suggested that the stocks are overvalued at the end of the 19905. In order to suggest that something is overvalued, one must always specify the point of reference. In class, we suggested that the point of reference for actions is value discounted future expected dividends: on f 3' 1 -e t'l'j 1:0 k=O +l'\" For simplicity, we will assume for the rest of the question that interest rates do not do not change over time 1. If one wants to argue that stock prices in the late 19905 were correct, it should therefore be assumed that investors have changed their expectations on interest rates and future dividends during the 19905. In what direction did these expectations had to change to justify the rise in share price? 2. The above expression was obtained by assuming that the agents are not averse at risk. Suppose they are risk averse and require a risk premium to hold shares. The condition of no arbitrage between bonds and equities then becomes: Df+1+Q:+1_l+i +9 1' Find the value of a stock in this case in terms of the present value of the future dividends. 3. To justify the stock price increase in terms of a change in the premium risk demanded by investors, in which direction should q change for raise the stock level? 4. What is the impact of rising stock prices on consumption and GDP in the short term? 5. What could the central bank do to reduce the GDP impact of the dramatic fall in share price since 2000