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Why Does the Fed Move Markets so Much? A Model of Monetary Policy and Time-Varying Risk Aversion

Author

Listed:
  • Carolin Pflueger
  • Gianluca Rinaldi

Abstract

We build a new model integrating a work-horse New Keynesian model with investor risk aversion that moves with the business cycle. We show that the same habit preferences that explain the equity volatility puzzle in quarterly data also naturally explain the large high-frequency stock response to Federal Funds rate surprises. In the model, a surprise increase in the short-term interest rate lowers output and consumption relative to habit, thereby raising risk aversion and amplifying the fall in stocks. The model explains the positive correlation between changes in breakeven inflation and stock returns around monetary policy announcements with long-term inflation news.

Suggested Citation

  • Carolin Pflueger & Gianluca Rinaldi, 2020. "Why Does the Fed Move Markets so Much? A Model of Monetary Policy and Time-Varying Risk Aversion," NBER Working Papers 27856, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:27856
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    More about this item

    JEL classification:

    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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