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
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.
New Economics Papers: this item is included in nep-cba, nep-mac and nep-mon
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Persistent link: https://EconPapers.repec.org/RePEc:diw:diwwpp:dp1605
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