Monetary Policy Rules and the Equity Premium

37 Pages Posted: 12 Dec 2015

See all articles by Anastasia S. Zervou

Anastasia S. Zervou

Texas A&M University - Department of Economics

Yulei Peng

Sun Yat-sen University (SYSU) - Lingnan (University) College

Date Written: September 18, 2014

Abstract

We study the effect of monetary policy on the equity premium using a segmented stock market model. Optimal monetary policy in our model involves risk-sharing and is countercyclical with respect to dividend shocks; thus, it implies low equity return compared to other policies, including inflation targeting. The optimal policy, however, does not guarantee inflation stability and produces higher nominal bond return compared to inflation targeting. Our calibration exercise finds equity premium of 7% under the inflation targeting policy and 1.5% under the optimal policy. We suggest that suboptimal policies focusing on inflation stability might result in high equity premia.

Keywords: equity premium, monetary policy, segmented financial markets

JEL Classification: E44, E52, G12

Suggested Citation

Zervou, Anastasia S. and Peng, Yulei, Monetary Policy Rules and the Equity Premium (September 18, 2014). Available at SSRN: https://ssrn.com/abstract=2498684 or http://dx.doi.org/10.2139/ssrn.2498684

Anastasia S. Zervou (Contact Author)

Texas A&M University - Department of Economics ( email )

5201 University Blvd.
College Station, TX 77843-4228
United States

Yulei Peng

Sun Yat-sen University (SYSU) - Lingnan (University) College ( email )

135 Xingang Xi Road
Tuen Mun
Guangzhou, Guangzhou 510275
China

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