MONETARY SHOCKS AND STOCK MARKET FLUCTUATIONS: WITH AN APPLICATION TO THE CHINESE STOCK MARKET

Abstract

Using a simple theoretical model, this paper provides a micro-foundation of applying vector auto-regressive (VAR) models to explore the effects of monetary shocks on stock market fluctuations. We analytically show that, when monetary shocks change investors’ wealth and portfolio liquidity, their degree of risk aversion associated with wealth and liquidity changes accordingly, which is then channeled to their investment decision and finally to the stock market fluctuations. Both the wealth effect and liquidity effect of monetary shocks have inter-temporal impacts on stock pricing. Therefore, monetary shocks and stock price fluctuations should be treated as a unified vector system that is auto-correlated. Based on the theoretical analysis, this paper further studies the impacts of different forms of monetary shocks on the Chinese stock market over the period 2005 to 2012 with a non-linear VAR model. We find that monetary shocks in China have significant and asymmetric effects on the stock market performance over different market cycles. Our estimation suggests that changes in monetary policy may increase stock market volatility, even though these monetary policies are often aimed at stabilizing the Chinese macro-economic activities.