Monetary Policy Risk and the Cross-Section of Stock Returns

Francisco Palomino and Xuenan Li

No 935, 2010 Meeting Papers from Society for Economic Dynamics

Abstract: The effects of monetary policy shocks on the equity premium and the cross-section of stock returns are analyzed in general equilibrium. Policy shocks affect real stock returns as a result of nominal product price rigidities. Two opposite effects determine the impact of policy shocks on stock returns. A contractionary shock increases the marginal utility of consumption, reduces aggregate output, and increases production markups. The output reduction requires a positive premium in expected returns. The markup increase acts as a consumption hedge and involves a negative premium. Low elasticities of intertemporal substitution of consumption and labor amplify the markup effect and can generate a negative net effect on the equity premium. In the cross-section, a contractionary shock reduces the relative output and expands the relative markup of a more rigid price industry with respect to a more flexible price industry. If the relative markup expansion dominates the relative output decline, the expected stock return of the more flexible price industry is higher than that of the more rigid price one. As the responsiveness of the policy to economic conditions increases, the effects of policy shocks on the equity premium and the cross-section decline. In addition, the policy-induced markup variation generates time variation in expected returns.

Date: 2010
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