Monetary Policy Responds to Stock Market Movements Dissertation

Monetary Policy Responds to Stock Market Movements - Dissertation Example According to Bernanke and Gertler (2001) changes in asset prices (including stock prices) should only impact monetary policies to the extent that they affect the central banks forecast of inflation. Therefore, the target of monetary policy is inflation and not specifically stock prices. Hayford and Malliaris (2002) used different methodologies to determine whether monetary policy has influenced the stock market since it crashed on October 19, 1987. The results indicate that, rather than using the Federal Funds rate policy to offset increases in the value of the stock market above estimates of fundamentals, Federal Fund policy has on average accommodated what is considered to be overvaluation of the stock market. Hayward and Malliaris (2002) found evidence in the FOMC minutes which is consistent with Taylor (1993). Taylor’s (1993) rule suggests that Federal Funds rate target has largely been st in response to inflation and measures of excess demand and therefore is not solely a response to offset potential stock market valuations. Rigobon and Sack (2003) employed an identification technique based on the heteroskedasticity of stock market returns in order to determine the response of monetary policy to stock market movements. Using daily and weekly movements in interest rates and stock prices between 1985 and 1999 Rigobon and Sack (2003) found that the response of monetary policy to stock market movements was significant. The results showed a 5% rise (fall) in the Standard and Poor’s (S&P) 500.... reases in the value of the stock market above estimates of fundamentals, Federal Fund policy has on average accommodated what is considered to be overvaluation of the stock market. Hayward and Malliaris (2002) found evidence in the FOMC minutes which is consistent with Taylor (1993). Taylor’s (1993) rule suggests that Federal Funds rate target has largely been st in response to inflation and measures of excess demand and therefore is not solely a response to offset potential stock market valuations. Rigobon and Sack (2003) employed an identification technique based on the heteroskedasticity of stock market returns in order to determine the response of monetary policy to stock market movements. Using daily and weekly movements in interest rates and stock prices between 1985 and 1999 Rigobon and Sack (2003) found that the response of monetary policy to stock market movements was significant. The results showed a 5% rise (fall) in the Standard and Poor’s (S&P) 500 Index, i ncreasing the possibility of a 25 basis point tightening (easing) by about one half. These results suggest that stock market movements have a significant impact on short term interest rates, driving them in the direction as the change in stock prices. This Rigobon and Sack (2003) attribute to the anticipated reaction of monetary policy to stock market increases. Fuhrer and Tootell (2004) focused on the fact that methods used in earlier literature fail to adequately separate what they describe as the observational equivalence problem. In addition Fuhrer and Tootell (2004) showed that after controlling for the information that that enters the Federal Open Market Committee’s (FOMC’s) decision making process stock market prices have had no independent effect on monetary policy. Cassala and Morena