Working Paper: CEPR ID: DP8387
Authors: Edouard Challe; Chryssi Giannitsarou
Abstract: Recent empirical literature documents that unexpected changes in the nominal interest rates have a significant effect on stock prices: a 25-basis point increase in the Fed funds rate is associated with an immediate decrease in broad stock indices that may range from 0.5 to 2.3 percent, followed by a gradual decay as 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 allows for staggered price and wage setting, as well as time-varying risk aversion through habit formation. We find that the model predicts a stock market response to policy shocks that matches empirical estimates, both qualitatively and quantitatively. Our findings are robust to a range of variations and parameterizations of the model.
Keywords: Asset Prices; Monetary Policy; New Keynesian General Equilibrium Model
JEL Codes: E31; E52; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Monetary policy shocks (E39) | Stock prices (G19) |
| Increase in federal funds rate (E52) | Decrease in broad U.S. stock indices (G19) |
| Monetary policy shocks (E39) | Stock market reaction (G10) |
| Stock market reaction (G10) | Stock prices (G19) |
| Nominal interest rate shock (E43) | Dynamic adjustment of stock prices (G19) |