Academic journal article Journal of Money, Credit & Banking

Does Monetary Policy Have Asymmetric Effects on Stock Returns?

Academic journal article Journal of Money, Credit & Banking

Does Monetary Policy Have Asymmetric Effects on Stock Returns?

Article excerpt

IT HAS BEEN OF GREAT interest to both macroeconomists and financial economists of whether monetary policy affects stock returns. A number of studies have empirically investigated the effects of monetary policy on stock returns. Using money aggregate data as a measure of money supply, some empirical studies agree that stock returns lag behind changes in monetary policy; for instance, see Keran (1971), Homa and Jaffee (1971), and Hamburner and Kochin (1972). In contrast, Cooper (1974), Pesando (1974), Rozeff (1974), and Rogalski and Vinso (1977) show that there is no significant forecasting power of past changes in money. Ever since the seminal paper by Bernanke and Blinder (1992), the Federal funds rate has been the most widely used measure of monetary policy. As such, the relationship between monetary policy and stock returns has been reexamined by using the interest rate instrument in the financial literature. Thorbecke (1997) and Patelis (1997) demonstrate that shifts in monetary policy help to explain U.S. stock returns. Conover, Jensen, and Johnson (1999) show that foreign stock returns generally react both to local and U.S. monetary policy.

Two important contributions to the literature on the effects of monetary policy on the stock market have been made. The first one emphasizes the roles of financial markets' expectations about the future course of monetary policy. Bernanke and Kuttner (2003) extract unanticipated monetary policy from Federal funds futures and find that monetary policy surprises appear to have a significant effect on equity prices through changes in the equity premium. The second focus is on the prospect of endogeneity. Rigobon and Sack (2003) show that the causality between interest rates and stock prices may run in both directions. After accounting for this endogeneity, they find a significant monetary policy response to the stock market.

Furthermore, cyclical variations in stock returns are widely reported in the literature. (1) Particularly, bull and bear markets have been explicitly identified in Maheu and McCurdy (2000), Pagan and Sossounov (2003), Edwards, Gomez Biscarri, and Perez de Gracia (2003), and Lunde and Timmermann (2004). Therefore, two interesting questions emerge. First, can the debate over the (in)significance of the effects of monetary policy as measured by money aggregates be resolved under a non-linear framework? Second, are the effects of monetary policy on stock returns asymmetric? That is, does a monetary policy have different impacts on stock returns in bull and bear markets? (2) The class of models in which there exist agency costs of financial intermediation (finance constraint) asserts that when there is information asymmetry in the financial market, agents may behave as if they are constrained financially. Moreover, the financial constraint is more likely to bind in bear markets. Hence, a monetary policy may have greater effects in bear markets. See Bernanke and Gertler (1989) and Kiyotaki and Moore (1997).

This paper empirically examines the asymmetric effects of monetary policy using a modified version of the Markov-switching model developed by Hamilton (1989). The effects of monetary policy are investigated in two different perspectives. First, I assume that monetary policy may affect stock returns directly in a fixed-transition-probability (FTP) Markov-switching model where the transition probabilities are fixed over time. Second, I consider a time-varying-transition-probability (TVTP) Markov-switching model and allow the probability of switching between states (bull markets versus bear markets) to depend on monetary policy.

This paper investigates many different measures of the stance of monetary policy: money aggregates (M2), discount rates (DR), Federal funds rates (FF), and VAR-based measures of monetary policy. Moreover, an event-study approach is also employed. It is worth noting that this paper is not the first one to study the possible asymmetric effects of monetary policy under a Markov-switching framework. …

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