The Effects of Monetary Policy on Stock Market Bubbles: Some Evidence

• Authors: Luca Gambetti and Jordi Galí.
• BSE Working Paper: 110209 | September 15
• Keywords: inflation targeting , financial stability , leaning against the wind policies , asset price booms
• JEL codes: E52, G12
• inflation targeting
• financial stability
• leaning against the wind policies
• asset price booms

We estimate the response of stock prices to exogenous monetary policy shocks using a vector-autoregressive model with time-varying parameters. Our evidence points to protracted episodes in which, after a a short-run decline, stock prices increase persistently in response to an exogenous tightening of monetary policy. That response is clearly at odds with the “conventional” view on the effects of monetary policy on bubbles, as well as with the predictions of bubbleless models. We also argue that it is unlikely that such evidence be accounted for by an endogenous response of the equity premium to the monetary policy shocks.