Asset Allocation and Monetary Policy: Evidence from the Eurozone

Abstract

The eurozone has a single short-term nominal interest rate, but monetary policy conditions measured by real short-term interest rates varied substantially across countries in the period 2003-2010. We use this cross-country variation in the (local) tightness of monetary policy to examine its influence on equity and money market flows. In line with a powerful risk-shifting channel, we find that fund investors in countries with decreased real interest rates shift their portfolio investment out of the money market and into the riskier equity market -- causing significant equity price inflation in countries where investment home bias is the strongest.

Keywords: monetary policy, asset price inflation, risk seeking, Taylor rule residuals

JEL Classification: G11, G14, G23