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Title: Stock Prices and Monetary Policy Shocks: A General Equilibrium Approach

Author(s): Edouard Challe and Chryssi Giannitsarou

Publication Date: May 2011

Keyword(s): Asset prices, Monetary policy and New Keynesian general equilibrium model

Programme Area(s): Financial Economics and International Macroeconomics

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.

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Bibliographic Reference

Challe, E and Giannitsarou, C. 2011. 'Stock Prices and Monetary Policy Shocks: A General Equilibrium Approach'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=8387