Does Fiscal Policy Matter for Stock-Bond Return Correlation?

Abstract

Switching between monetary and fiscal regimes is incorporated in a general-equilibrium model to explain three stylized facts: (1) a positive correlation of stock and bond returns in 1971-2001 and a negative correlation after 2001, (2) a negative correlation of consumption and inflation in 1971-2001 and a positive correlation after 2001, and (3) the coexistence of a positive bond risk premium and a negative correlation of stock and bond returns. While the technology shock drives the positive stock-bond and negative consumption-inflation correlations in the monetary regime, the investment shock drives the negative stock-bond and positive consumption-inflation correlations in the fiscal regime.

Keywords: Stock-bond return correlation, consumption-inflation correlation, fiscal-monetary policy regime, bond risk premium, technology shock, investment shock

JEL Classification: G12, G18, E52, E62