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Monetary Policy Risk and the Cross-Section of Stock Returns

Author

Listed:
  • Francisco Palomino

    (University of Michigan)

  • Erica Li

    (University of Michigan)

Abstract

The effects of monetary policy shocks on the equity premium and the cross-section of stock returns are analyzed in general equilibrium. Policy shocks affect real stock returns as a result of nominal product price rigidities. Two opposite effects determine the impact of policy shocks on stock returns. A contractionary shock increases the marginal utility of consumption, reduces aggregate output, and increases production markups. The output reduction requires a positive premium in expected returns. The markup increase acts as a consumption hedge and involves a negative premium. Low elasticities of intertemporal substitution of consumption and labor amplify the markup effect and can generate a negative net effect on the equity premium. In the cross-section, a contractionary shock reduces the relative output and expands the relative markup of a more rigid price industry with respect to a more flexible price industry. If the relative markup expansion dominates the relative output decline, the expected stock return of the more flexible price industry is higher than that of the more rigid price one. As the responsiveness of the policy to economic conditions increases, the effects of policy shocks on the equity premium and the cross-section decline. In addition, the policy-induced markup variation generates time variation in expected returns.

Suggested Citation

  • Francisco Palomino & Erica Li, 2010. "Monetary Policy Risk and the Cross-Section of Stock Returns," 2010 Meeting Papers 935, Society for Economic Dynamics.
  • Handle: RePEc:red:sed010:935
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    References listed on IDEAS

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    Cited by:

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    2. Challe, Edouard & Giannitsarou, Chryssi, 2014. "Stock prices and monetary policy shocks: A general equilibrium approach," Journal of Economic Dynamics and Control, Elsevier, vol. 40(C), pages 46-66.

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