Stock Prices and Monetary Policy Shocks: A General Equilibrium Approach

Abstract

Abstract. Recent empirical literature documents that unexpected changes in the nominal interest rates have a signi…cant e¤ect on real stock prices: a 25-basis point increase in the nominal interest rate is associated with an immediate decrease in broad real stock indices that may range from 0.6 to 2.2 percent, followed by a gradual decay as real stock prices revert towards their long-run expected value. In this paper, we assess the ability of a general equilibrium New Keynesian asset-pricing model to account for these facts. The model we consider is a production economy with elastic labor supply, staggered price and wage setting, as well as time-varying risk aversion through habit formation. We …nd that the model predicts a stock market response to policy shocks that matches empirical estimates, both qualitatively and quantitatively. Our …ndings are robust to a range of variations and parameterizations of the model.

Monetary policy shocks and financial conditions: A Monte Carlo experiment

“…To our knowledge, this is the first contribution exploiting the KCFSI, and a financial conditions index in general, as an observable to estimate a DSGE model embedding a financial channel for the U.S. economy. Challe and Giannitsarou (2010) build up a model in which stocks are priced consistently with households' optimization problem but do not exert any impact on consumption. They aim to show that a calibrated DSGE model is able to replicate the reaction of stock prices to a monetary policy shock as estimated by some VAR analysis.…”

“…They aim to show that a calibrated DSGE model is able to replicate the reaction of stock prices to a monetary policy shock as estimated by some VAR analysis. With respect to Challe and Giannitsarou (2010), we allow for a twoway interaction between the real and the financial part of the system, and we estimate our framework with U.S. data instead of resorting to calibration.…”

Asset pricing in the production economy subject to monetary shocks

“…Bernanke and Kuttner (2005) show that a hypothetical 25-basis point cut in the Federal Reserve funds target rate leads to about a 1% increase in broad stock indices. Challe and Giannitsarou (2010) provide similar empirical evidence of the adverse effect of the unexpected monetary shock on the stock market: they show that 1% unexpected increase in the nominal short rate results in the negative impact ranging from −2% to −9% in US and European countries. My work is also related to Bakshi and Chen (1996) who solve simultaneously for the price level, inflation, asset prices, and derive real and nominal term structures in the monetary asset pricing model.…”

“…Dellas (2006) sets = 0.008. Challe and Giannitsarou (2010) set this parameter equal to zero. 20 See endnote 22 in their paper.…”

Learning about the interdependence between the macroeconomy and the stock market

“…The estimates for the post-1984 sample (Table 3), however, indicate a posterior mean for γ equal to 0.009, which remains substantially at the same level as the full-sample result. 18 When the model is estimated assuming that stock prices do not affect the formation of expectations, the posterior mean for γ, in the full sample case, becomes larger (γ = 0.033, Table 3). The fit of the model, however, would be worse.…”