Does Fiscal Policy Matter for Stock-Bond Return Correlation?

Abstract

We explore an important role of monetary-fiscal policy interactions in explaining three stylized facts: (1) a positive correlation of stock and bond returns in 1971-2001 and a negative one after 2001, (2) a negative correlation of consumption and inflation in 1971-2001 and a positive one after 2001, and (3) the coexistence of a positive bond risk premium and a negative correlation of stock and bond returns. Our general equilibrium model shows that these correlation changes across two policy regimes are driven by a combination of technology and investment shocks, while positive risk premiums are driven by the technology shock only.