DP10070 The Effects of Monetary Policy on Stock Market Bubbles: Some Evidence

Author(s): Jordi Galí, Luca Gambetti
Publication Date: July 2014
Keyword(s): asset price booms, financial stability, inflation targeting, leaning against the wind policies
JEL(s): E52, G12
Programme Areas: International Macroeconomics, Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=10070

We estimate the response of stock prices to exogenous monetary policy shocks using a vector-autoregressive model with time-varying parameters. Our evidence points to protracted episodes in which stock prices end up increasing persistently in response to an exogenous tightening of monetary policy, even though they experience a small decline in the short run. That response is clearly at odds with the "conventional" view on the effects of monetary policy on bubbles, as well as with the predictions of bubbleless models. We also argue that it is unlikely that such evidence be accounted for by an endogenous response of the equity premium to the monetary policy shocks.