Why Does the Fed Move Markets so Much? A Model of Monetary Policy and Time-Varying Risk Aversion

81 Pages Posted: 30 Sep 2020

See all articles by Carolin E. Pflueger

Carolin E. Pflueger

University of Chicago - Harris School of Public Policy; National Bureau of Economic Research (NBER)

Gianluca Rinaldi

Harvard University, Department of Economics

Multiple version iconThere are 2 versions of this paper

Date Written: September 28, 2020

Abstract

We build a new model integrating a work-horse New Keynesian model with investor risk aversion that moves with the business cycle. We show that the same habit preferences that explain the equity volatility puzzle in quarterly data also naturally explain the large high-frequency stock response to Federal Funds rate surprises. In the model, a surprise increase in the short-term interest rate lowers output and consumption relative to habit, thereby raising risk aversion and amplifying the fall in stocks. The model explains the positive correlation between changes in breakeven inflation and stock returns around monetary policy announcements with long-term inflation news.

JEL Classification: E43,E44,E52,G12

Suggested Citation

Pflueger, Carolin E. and Rinaldi, Gianluca, Why Does the Fed Move Markets so Much? A Model of Monetary Policy and Time-Varying Risk Aversion (September 28, 2020). University of Chicago, Becker Friedman Institute for Economics Working Paper No. 2020-138, Available at SSRN: https://ssrn.com/abstract=3701681 or http://dx.doi.org/10.2139/ssrn.3701681

Carolin E. Pflueger (Contact Author)

University of Chicago - Harris School of Public Policy ( email )

1155 East 60th Street
Chicago, IL 60637
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Gianluca Rinaldi

Harvard University, Department of Economics ( email )

Cambridge, MA
United States

HOME PAGE: http://scholar.harvard.edu/rinaldi

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