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The response of asset prices to monetary policy shocks: stronger than thought

Lucia Alessi () and Mark Kerssenfischer

No 1967, Working Paper Series from European Central Bank

Abstract: Mainstream macroeconomic theory predicts a rapid response of asset prices to monetary policy shocks, which conventional empirical models are unable to reproduce. We argue that this is due to a deficient information set: Forward-looking economic agents observe vastly more information than the handful of variables included in standard VAR models. Thus, small-scale VARs are likely to suffer from nonfundamentalness and yield biased results. We tackle this problem by estimating a Structural Factor Model for a large euro area dataset. We find quicker and larger effects of monetary policy shocks, consistent with mainstream theory and the observed large swings in asset prices. Our results point to stronger financial stability consequences of an exogenous monetary policy tightening, also in the form of a quicker than expected unwinding of QE, than commonly thought. JEL Classification: C32, E43, E44, E52

Keywords: Asset Prices; monetary policy; Nonfundamentalness.; Structural Factor Models (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-eec, nep-mac and nep-mon
Date: 2016-09
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