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

Carolin Pflueger () and Gianluca Rinaldi ()
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Carolin Pflueger: University of Chicago - Harris School of Public Policy; National Bureau of Economic Research (NBER)
Gianluca Rinaldi: Harvard University, Department of Economics

No 2020-138, Working Papers from Becker Friedman Institute for Research In Economics

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.

Pages: 81 pages
Date: 2020
New Economics Papers: this item is included in nep-dge, nep-mac and nep-mon
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Persistent link: https://EconPapers.repec.org/RePEc:bfi:wpaper:2020-138

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