Monetary Policy Shocks and Stock Returns: Identification Through Impossible Trinity

40 Pages Posted: 16 Sep 2011 Last revised: 20 Sep 2013

See all articles by Ali K. Ozdagli

Ali K. Ozdagli

Federal Reserve Banks - Federal Reserve Bank of Boston

Yifan Yu

Federal Reserve Banks - Federal Reserve Bank of Boston

Date Written: September 16, 2011

Abstract

This paper aims to identify the effect of monetary policy shocks on stock prices through the lens of Mundell and Fleming’s “Impossible Trinity” theory. Our identification strategy seeks to solve the simultaneity and omitted variable problems inherent in studies that focus on the effect of monetary policy on asset prices. Moreover, we use our identification strategy to test the hypothesis that stock prices of financially constrained firms are more responsive to monetary policy shocks. Our results so far do not support this hypothesis, which seems to contradict the financial accelerator theory presented in Bernanke, Gertler, and Gilchrist (1999) but is consistent with Lamont, Polk, and Sa´a-Requejo (2001) who find that the relative stock market performance of constrained firms does not reflect monetary policy or credit conditions.

Keywords: Equity prices, monetary policy, financial frictions, financial accelerator, simultaneity, omitted variables

JEL Classification: E44, E52, E58, G12, G15, G18, G32, G38

Suggested Citation

Ozdagli, Ali K. and Yu, Yifan, Monetary Policy Shocks and Stock Returns: Identification Through Impossible Trinity (September 16, 2011). Midwest Finance Association 2012 Annual Meetings Paper. Available at SSRN: https://ssrn.com/abstract=1928614 or http://dx.doi.org/10.2139/ssrn.1928614

Ali K. Ozdagli (Contact Author)

Federal Reserve Banks - Federal Reserve Bank of Boston ( email )

600 Atlantic Avenue
Boston, MA 02210
United States

HOME PAGE: http://sites.google.com/site/ozdagli/

Yifan Yu

Federal Reserve Banks - Federal Reserve Bank of Boston ( email )

600 Atlantic Avenue
Boston, MA 02210
United States

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