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Monetary Policy and Mispricing in Stock Markets

Benjamin Beckers and Kerstin Bernoth ()

No 1605, Discussion Papers of DIW Berlin from DIW Berlin, German Institute for Economic Research

Abstract: This paper investigates whether central banks can attenuate excessive mispricing in stocks as suggested by the proponents of a "leaning against the wind" (LATW) monetary policy. For this, we decompose stock prices into a fundamental component, a risk premium, and a mispricing component. We argue that mispricing can arise for two reasons: (i) from false subjective expectations of investors about future fundamentals and equity premia; and (ii) from the inherent indeterminacy in asset pricing in line with rational bubbles. We show that the response of the excessive stock price component to a monetary policy shock is ambiguous in both the short- and long-run, and depends on the nature of the mispricing. Subsequently, we evaluate the scope for a LATW policy empirically by employing a time-varying coefficient VAR with a flexible identification scheme based on impact and long-run restrictions using data for the S&P500 index from 1962Q1 to 2014Q4. We find that a contractionary monetary policy shock in fact lowers stock prices beyond what is implied by the response of their underlying fundamentals.

Keywords: Asset pricing; bubbles; financial stability; leaning against the wind; mispricing; monetary policy; time-varying coefficient VAR; zero and sign restrictions (search for similar items in EconPapers)
JEL-codes: E44 E52 E58 G12 G14 (search for similar items in EconPapers)
Pages: 48 p.
Date: 2016
New Economics Papers: this item is included in nep-cba, nep-mac and nep-mon
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