Working Paper Series no. 330: Stock Prices and Monetary Policy Shocks: A General Equilibrium Approach

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.

Edouard Challe and Chryssi Giannitsarou
June 2011

Classification JEL : E31, E52, G12

Keywords : Monetary policy; Asset prices; New Keynesian general equilibrium model