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Stock Prices and Monetary Policy Shocks: A General Equilibrium Approach

  • Challe, E.
  • Giannitsarou, C.

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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Paper provided by Banque de France in its series Working papers with number 330.

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Length: 31 pages
Date of creation: 2011
Date of revision:
Handle: RePEc:bfr:banfra:330
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