The impact of stock market volatility on monetary policy Dissertation

The impact of stock market volatility on monetary policy - Dissertation Example This section presents the results of the estimation. In table 1 we present the results of running regression specifications (1) and (2) using OLS and GMM instrumental variable estimation. We have used the S and P 500, Dow Jones as well as the FTSE 100 indices as measures of stock market prices. All three have been included to verify whether the results obtained are robust to changes in stock market indices. For the GMM estimation, lagged values of inflation and the output gap have been used as instruments. Finally, we have incorporated a recession dummy in the 2nd specification. This dummy variable takes the value 1 for all quarters between 2007 Q3 and 2009 Q4. In table 1, the 1st column presents the results of running a simple OLS regression on equation (1). The intercept and the coefficient on inflation are positive and significant. However, the coefficient on the output gap, although quite large is not statistically significant. Thus, from the 1st column where the estimation was c arried out of equation (1) we find that the interest rate responds only to the inflation. It does not respond to the output gap. Also, from the last row which presents the Wald test statistic which tests the hypothesis ÃŽ ² = ÃŽ ³ = 0.5, we find the statistic is highly significant. So, the null hypothesis is rejected by the 1st model.   In column 2, the results of estimating the OLS specification (2) are presented. The wald test statistic is 89.25 which is highly significant.... This translates into the query of whether equity price levels as measured by indices such as the Dow Jones or the Standard and Poor 500 should be targeted explicitly by monetary policy or not. Most macroeconomists however are of the opinion that pursuing these queries is not worthwhile since targeting stock market prices requires identification of what the fundamental prices of an asset is before the extent to which the actual price has deviated from the fundamental or target price can be identified. In other words, ex-ante identification of a stock market bubble is extremely difficult. Since the fundamental price of a stock is not verifiable then the nature of deviation of actual prices remains unverifiable as well (Shiller, 1989; Salge, 1997). Bubbles, i.e., increase of prices steadily above fundamentals can be identified ex-post. In hindsight it is clear that the Nasdaq rise or the steady rise in Japanese asset prices in the late 1980’s were such bubbles. But during the res pective phases these movements were not convincingly identified as anything other than reflecting fundamental price dynamics. Therefore under these difficulties of recognising stock market volatility in real time the true complexity of asking what the reaction of monetary authorities should be becomes clear. One possible direction suggested in literature is to make the simplifying assumption that the monetary authority is aware of the presence of a bubble and realizes that the collapse of the bubble is imminent. Post-collapse prices will revert back to the fundamental levels. Then ask what the appropriate reaction of the monetary authority should be under such assumptions. (Blanchard, 2000) Opinion among economists