Measuring the Reaction of Monetary Policy to the Stock Market

32 Pages Posted: 11 Jun 2001

See all articles by Roberto Rigobon

Roberto Rigobon

Massachusetts Institute of Technology (MIT) - Sloan School of Management; National Bureau of Economic Research (NBER)

Brian P. Sack

Board of Governors of the Federal Reserve - Monetary and Financial Market Analysis Section

Multiple version iconThere are 2 versions of this paper

Date Written: February 23, 2001

Abstract

Movements in the stock market can have a significant impact on the macroeconomy and are therefore likely to be an important factor in the determination of monetary policy. However, little is known about the magnitude of the Federal Reserve's reaction to the stock market. One reason is that it is difficult to estimate the policy reaction because of the simultaneous response of equity prices to interest rate changes. This paper uses an identification technique based on the heteroskedasticity of stock market returns to identify the reaction of monetary policy to the stock market. The results indicate that monetary policy reacts significantly to stock market movements, with a 5% rise (fall) in the S&P 500 index increasing the likelihood of a 25 basis point tightening (easing) by about a half. This reaction is roughly of the magnitude that would be expected from estimates of the impact of stock market movements on aggregate demand. Thus, it appears that the Federal Reserve systematically responds to stock price movements only to the extent warranted by their impact on the macroeconomy.

Keywords: Monetary policy, stock market, identification, heteroskedasticity

JEL Classification: E44, E47, E52

Suggested Citation

Rigobon, Roberto and Sack, Brian P., Measuring the Reaction of Monetary Policy to the Stock Market (February 23, 2001). FEDS Working Paper No. 2001-14. Available at SSRN: https://ssrn.com/abstract=268288 or http://dx.doi.org/10.2139/ssrn.268288

Roberto Rigobon

Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )

E52-447
Cambridge, MA 02142
United States
617-258-8374 (Phone)
617-258-6855 (Fax)

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Brian P. Sack (Contact Author)

Board of Governors of the Federal Reserve - Monetary and Financial Market Analysis Section ( email )

20th and C Streets, NW
Washington, DC 20551
United States
202-736-5671 (Phone)
202-452-2301 (Fax)

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