Risk, Uncertainty and Monetary Policy
44 Pages Posted: 27 Dec 2010
Date Written: December 2010
We document a strong co-movement between the VIX, the stock market option-based implied volatility, and monetary policy. We decompose the VIX into two components, a proxy for risk aversion and expected stock market volatility ("uncertainty"), and analyze their dynamic interactions with monetary policy in a structural vector autoregressive framework. A lax monetary policy decreases risk aversion after about five months. Monetary authorities react to periods of high uncertainty by easing monetary policy. These results are robust to controlling for business cycle movements. We further investigate channels through which monetary policy may affect risk aversion, e.g., through its effects on broad liquidity measures and credit.
Keywords: business cycle, monetary policy, option implied volatility, risk aversion, stock market volatility dynamics, uncertainty
JEL Classification: E32, E44, E52, G12, G20
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