American Economic Journal: Macroeconomics 2015, 7(1): 233–257

http://dx.doi.org/10.1257/mac.20140003

The Effects of Monetary Policy

on Stock Market Bubbles: Some Evidence †
By Jordi Galí and Luca Gambetti *

We estimate the response of stock prices to monetary policy

shocks using a time-varying coefficients VAR. Our evidence points
to protracted episodes in which stock prices end up increasing
persistently in response to an exogenous tightening of monetary
policy. That response is at odds with the “conventional” view
on the effects of monetary policy on bubbles, as well as with the
predictions of bubbleless models. We also argue that it is unlikely
that such evidence can be accounted for by an endogenous
response of the equity premium to the monetary policy shock.
(JEL E43, E44, E52, G12, G14)

T he economic and financial crisis of 2008–2009 has been associated in many

countries with a rapid decline in housing prices, following a protracted real
estate boom. This has generated a renewed interest in the link between monetary
policy and asset price bubbles, and revived the long standing debate on whether and
how monetary policy should respond to perceived deviations of asset prices from
fundamentals.1
The consensus view before the crisis was that central banks should focus on sta-
bilizing inflation and the output gap, and ignore fluctuations in asset prices, even if
the latter are perceived to be driven by bubbles.2 The recent crisis has challenged

* Galí: Centre de Recerca en Economia Internacional (CREI), Universitat Pompeu Fabra and Barcelona GSE
Ramon Trias Fargas, 25-27 08005-Barcelona, Spain. (e-mail: [email protected]); Gambetti: Universitat Autonoma de
Barcelona and Barcelona GSE. Departament d’Economia i d’Historia Economica, Edifici B, Universitat Autònoma
de Barcelona, 08193 Bellaterra, (Barcelona), Spain. (e-mail: [email protected]). We have benefited from
comments by Andrea Ferrero, Mark Gertler, Refet Gürkeynak, Lucrezia Rieichlin, an anonymous referee, and
seminar and conference participants at UB, Centro de Estudios Monetarios y Financieros (CEMFI), New York
University (NYU), the Barcelona GSE Summer Forum, the Time Series Econometric Workshop (U. Zaragoza),
the Norges Bank Conference on “The Role of Monetary Policy Revisited,” the National Bureau of Economic
Research (NBER) Conference on “Lessons for the Financial Crisis from Monetary Policy” and the Observatoire
français des conjonctures économiques (OFCE) Workshop on Empirical Monetary Economics. Galí acknowledges
the European Research Council for financial support under the European Union’s Seventh Framework Programme
(FP7/2007–2013, ERC Grant agreement nº 339656). Gambetti gratefully acknowledges the financial support of
the Spanish Ministry of Economy and Competitiveness through grant ECO2012-32392 and the Barcelona GSE
Research Network.
† 
Go to http://dx.doi.org/10.1257/mac.20140003 to visit the article page for additional materials and author
disclosure statement(s) or to comment in the online discussion forum.
1 
Throughout the paper we use the term “monetary policy” in the narrow sense of “interest rate policy.” Thus,
we exclude from that definition policies involving macroprudential instruments that are sometimes controlled by
central banks and that may also be used to stabilize asset prices. 
2 
See, e.g., Bernanke and Gertler (1999, 2001) and Kohn (2006). Two arguments have been often pointed to in
support of that view: (i) asset price bubbles are difficult to detect and measure, and (ii) interest rates are “too blunt”
an instrument to prick a bubble, and their use with that purpose may have unintended collateral damages. 
234 American Economic Journal: macroeconomics January 2015

that consensus and has strengthened the viewpoint that central banks should pay
attention and eventually respond to developments in asset markets. Supporters of
this view argue that monetary authorities should “lean against the wind,” i.e., raise
the interest rate to counteract any bubble-driven episode of asset price inflation, even
at the cost of temporarily deviating from their inflation or output gap targets. Any
losses associated with these deviations, it is argued, would be more than offset by
the avoidance of the consequences of a future burst of the bubble.3
A central tenet of the case for “leaning against the wind” monetary policies is the
presumption that an increase in interest rates will reduce the size of an asset price
bubble. While that presumption may have become part of the received wisdom, no
empirical or theoretical support seems to have been provided by its advocates.
In recent work (Galí 2014), one of us has challenged, on theoretical grounds,
the link between interest rates and asset price bubbles underlying the conventional
view. The reason is that, at least in the case of rational asset price bubbles, the bub-
ble component must grow, in equilibrium, at the rate of interest. If that is the case,
an interest rate increase may end up enhancing the size of the bubble. Furthermore,
and as discussed below, the theory of rational bubbles implies that the effects of
monetary policy on asset prices should depend on the relative size of the bubble
component. More specifically, an increase in the interest rate should have a negative
impact on the price of an asset in periods where the bubble component is small com-
pared to the fundamental. The reason is that an interest rate increase always reduces
the “ fundamental” price of the asset, an effect that should be dominant in “normal”
times, when the bubble component is small or nonexistent. But if the relative size of
the bubble is large, an interest rate hike may end up increasing the asset price over
time, due to its positive effect on the bubble more than offsetting the negative impact
on the fundamental component.
In the present paper we provide evidence on the dynamic response of stock prices
to monetary policy shocks, and try to use that evidence to infer the nature of the
impact of interest rate changes on the (possible) bubble component of stock prices.
Our main goal is to assess the empirical merits of the “conventional” view, which
predicts that the size of the bubble component of stock prices should decline in
response to an exogenous increase in interest rates. Since the fundamental com-
ponent is expected to go down in response to the same policy intervention, any
evidence pointing to a positive response of observed stock prices (i.e., of the sum of
the fundamental and bubble components) to an exogenous interest rate hike would
call into question the conventional view regarding the effects of monetary policy on
stock price bubbles.
Our starting point is an estimated vector-autoregression (VAR) on quarterly US
data for GDP, the GDP deflator, a commodity price index, dividends, the federal
funds rate, and a stock price index (S&P 500). Our identification of monetary pol-
icy shocks is based on the approach of Christiano, Eichenbaum, and Evans (2005;
henceforth, CEE), though our focus here is on the dynamic response of stock prices
to an exogenous hike in the interest rate. Also, and in contrast with CEE, we allow

3 
See, e.g., Borio and Lowe (2002) and Cecchetti et al. (2000) for an early defense of “leaning against the wind”
policies. 
Vol.7 No.1 Galí and Gambetti: Monetary Policy and Bubbles 235

for time variation in the VAR coefficients, which results in estimates of time-varying
impulse responses of stock prices to policy shocks.4 In addition to the usual motiva-
tions for doing this (e.g., structural change), we point to a new one which is specific
to the issue at hand: to the extent that changes in interest rates have a different impact
on the fundamental and bubble components, the overall effect on the observed stock
price may change over time as the relative size of the bubble changes.
Under our baseline specification, which assumes no contemporaneous response of
monetary policy to asset prices, the evidence points to protracted episodes in which
stock prices increase persistently in response to an exogenous tightening of monetary
policy. That response is clearly at odds with the “conventional” view on the effects
of monetary policy on bubbles, as well as with the predictions of bubbleless models.
We assess a variety of alternative explanations for our findings. In particular,
we argue that it is unlikely that such evidence be accounted for by an endogenous
response of the equity premium to the monetary policy shocks.
When we allow for an endogenous contemporaneous response of interest rates to
stock prices, and calibrate the relevant coefficient in the monetary policy rule accord-
ing to the findings in Rigobon and Sack (2003), our findings change dramatically:
stock prices decline substantially in response to a tightening of monetary policy, more
so than our estimated fundamental components. That finding would seem to vindicate
the conventional view on the effectiveness of leaning against the wind policies. Recent
evidence by Furlanetto (2011), however, suggests that Rigobon and Sack’s finding is
largely driven by the Federal Reserve’s response to the stock market crash of 1987,
thus calling into question the relevance of this alternative specification for much of the
sample period analyzed, while supporting instead our baseline specification.
Ultimately, our objective is to produce evidence that can improve our understand-
ing of the impact of monetary policy on asset prices and asset price bubbles. That
understanding is a necessary condition before one starts thinking about how monetary
policy should respond to asset prices.
The remainder of the paper is organized as follows. In Section I we discuss alterna-
tive hypothesis on the link between interest rates and asset prices. Section II describes
our empirical model. In Section III we report the main findings under our baseline
specification. Section IV provides alternative interpretations as well as evidence based
on an alternative specification. Section V concludes.

I.  Monetary Policy and Asset Price Bubbles: Theoretical Issues

We use a simple partial equilibrium asset pricing model to introduce some key
concepts and notation used extensively below.5 We assume an economy with risk
neutral investors and an exogenous, time-varying (gross) riskless real interest rate​​
R​t​​.6 Let ​Q
​ ​t​​denote the price in period t​​of an infinite-lived asset, yielding a dividend
stream ​{​D​t​}​.

See, e.g., Primiceri (2005) and Galí and Gambetti (2009) for some macro applications of the TVC-VAR
4 

methodology. 
5 
See Galí (2014) for a related analysis in general equilibrium. 
6 
Below we discuss the implications of relaxing the risk neutrality assumption and allowing for a risk premium. 
236 American Economic Journal: macroeconomics January 2015

We interpret that price as the sum of two components: a “fundamental” compo-

nent, ​​Q​ Ft​ ​​ , and a “bubble” component, ​​Q ​tB​ ​​. Formally,

(1) ​​Q​t​  =  ​Q​ Ft​ ​ + ​Q​ tB​ ​​

where the fundamental component is defined as the present discounted value of

future dividends:

{k=1 ( j=0 ) }
∞ k−1
(2) ​​Q ​Ft​ ​  ≡  ​E​ t​ ​ ​ ∑  ​ ​  ​ ∏​  
​ (1/​Rt+j
​ ​) ​Dt+k
​ ​ ​ ​

or, rewriting it in log-linear form (and using lower case letters to denote the logs of
the original variables)7
∞
(3) ​ ​ Ft​ ​  =  const + ​ ∑ ​ ​Λ​ k​[(1 − Λ)​E​ t​{​d​ t+k+1​} − ​E​ t​{​r​ t+k​} ]​​,
​q
k=0

where ​Λ  ≡  Γ/R  <  1​ , with ​Γ​and ​R​are denoting, respectively, the (gross) rates of
dividend growth and interest along a balanced growth path.

How does a change in interest rates affect the price of an asset that contains a bub-
ble? We can seek an answer to that question by combining the dynamic responses
of the two components of the asset price to an exogenous shock in the policy rate.
t​ ​​ , we have:
Letting that shock be denoted by ​ε​ ​ m

∂ ​q​ ​
____ ∂ ​q​    ​  F
∂ ​q​    ​  B
(4) ​  t+k   =  (1 − ​γ​ t−1​)____
m ​
  ​  t+k m ​  + ​γ ​t−1____
 
  ​  t+k m ​  
 
​
∂ ​ε​ t​ ​ ∂ ​ε​ t​ ​ ∂ ​ε​ t​ ​

where ​​γ​ t​  ≡  ​Q​ tB​ ​ / ​Qt​​​denotes the share of the bubble in the observed price in period ​t​.

Using (2), we can derive the predicted response of the fundamental component

  ​ 
∂ ​q​ Ft+k ∞
Λ​ j​((1 − Λ)​______
t​ ​ )
∂ ​d​ t+k+j+1​ ∂ ​r​ t+k+j​
(5) ​ ____ m ​ 
   =  ​ ∑ ​​     ∂ ​ε​ m​  ​   − ​ ____
​      
​ ​​.
∂ ​ε​ t​ ​ j=0 t ∂ ​ε​ m

Both conventional wisdom and economic theory (as well as the empiri-
cal evidence discussed below) point to a rise in the real interest rate and a
decline in dividends in response to an exogenous tightening of monetary policy,
i.e., ​∂ ​r​ t+k​ /  ∂ ​ε ​m
t​ ​  >  0​and ​∂ ​d​ t+k​ / ∂ ​ε​ t​ ​  ≤  0​for ​k  =  0, 1, 2, …​Accordingly, the fun-
m

damental component of asset prices is expected to decline in response to such a

shock, i.e., we expect ​∂ ​q​ Ft+k   ​  /  ∂ ​ε​ m
t​ ​  <  0​for k​   =  0, 1, 2, …​

7 
See, e.g., Cochrane (2001, 395) for a derivation. 
Vol.7 No.1 Galí and Gambetti: Monetary Policy and Bubbles 237

Under the “conventional view” on the effects of monetary policy on asset price
bubbles we have, in addition:

∂ ​q​    ​ 
____
B
(6) ​  t+k ​   
  ≤  0​
∂ ​ε​ m
t​ ​

for ​k  =  0, 1, 2, …​ i.e., a tightening of monetary policy should cause a decline in
the size of the bubble. Hence, the overall effect on the observed asset price should be
unambiguously negative, independently of the relative size of the bubble:
∂ ​qt​+k​
​ ____  ​ 
  <  0​
∂ ​ε​ m
t​ ​

for ​k  =  0, 1, 2, …​

As argued in Galí (2014), however, the premise of a decline in the size of the bub-
ble in response to a interest rate hike does not have a clear theoretical underpinning.
In fact, the theory of rational asset price bubbles opens the door for a very different
prediction. To see this, note that the following difference equation must hold in a
rational expectations equilibrium:

(7) ​​Qt​​ R​t​  =  ​E​ t​{​Dt​+1​ + ​Qt​+1​}​.

It can be easily checked that (2) satisfies

(8) t​ ​R​t​  =  ​E​ t​{​Dt​+1​ + ​Q​ t+1

​​Q ​F  F
  ​} ​.

Using (1), (7), and (8), it can be easily checked that the bubble component must
satisfy:8

(9) ​​Q ​tB​ ​ R​t​  =  ​E​ t​{​Q​ tB+1

  ​ 
}​

or, equivalently, in its log-linear version:

​​E​ t​{Δ​q​ tB+1
  ​ 
}  =  ​r​ t​​.

Hence, an increase in the interest rate will raise the expected growth of the bubble
component. Note that the latter corresponds to the bubble’s expected return, which—
under the risk neutrality assumption made here—must be equal to the interest rate.
Accordingly, and as discussed in Galí (2014), any rule that implies a systematic
positive response of the interest rate to the size of the bubble, will tend to amplify
the movements in the latter—an outcome that calls into question the conventional
wisdom about the relation between interest rates and bubbles.

8 
Transversality conditions generally implied by optimizing behavior of infinite-lived agents are often used to
rule out such a bubble component (see, e.g., Santos and Woodford 1997). That constraint does not apply to econo-
mies with overlapping generations of finitely-lived agents (e.g., Samuelson 1958; Tirole 1985). 
238 American Economic Journal: macroeconomics January 2015

Changes in interest rates, however, may also affect the bubble through a second
channel: a possible systematic comovement between the (indeterminate) innovation
in the bubble with the surprise component of the interest rate. To see this, evaluate
the previous expression at ​t − 1​and eliminate the expectational operator to obtain:

(10) ​Δ​q​ tB​ ​  =  ​r​ t−1​ + ​ξ ​t​​

where ​​ξ​ t​  ≡  ​q​ tB​ ​ − ​E​ t−1​{​q​ tB​ ​}​ is an arbitrary process satisfying ​E

​ ​ t−1​{​ξ​ t​}  =  0​for all t​​
(i.e., the martingale-difference property). Note that the unanticipated change (“inno-
vation”) in the size of the bubble, ​​ξ​ t​​ , may or may not be related to fundamentals and,
in particular, to the interest rate innovation, ​r​ ​ t​ − ​E​ t−1​{​r​ t​}​. Thus, and with little loss
of generality, one can write:

(11) ​​ξ ​t​  =  ​ψt​​(​r​ t​ − ​E​ t−1​{​r​ t​}) + ​ξ ​∗t​ ​​,

where ​​ψt​​​ is a (possibly random) parameter and {​ ​ξ​ ∗t​ ​}​ is a zero-mean martin-

gale-difference process, respectively satisfying the orthogonality conditions.
​​E​ t−1​{​ψt​​(​r​ t​ − ​E​ t−1​{​r​ t​})}  =  0​ and ​E ​ ​ t−1​{​ξ​ ∗t​ ​ψt​​(​r​ t​ − ​E​ t−1​{​r​ t​})}  =  0​. Note that neither
the sign nor the size of ​​ψ​t​​ , nor its possible dependence on the policy regime, are
pinned down by the theory. Accordingly, the contemporaneous impact of an interest
rate innovation on the bubble is, in principle, indeterminate.
The dynamic response of the bubble component to a monetary policy tightening
is given by
⎧ ____ ∂ ​r​ t​
∂  ​  
​    
​ ⎪​ψt​​ ∂ ​ε​ m   ​         
t​ ​
  for k  =  0
⎨
B
____q +k
(12) ​  m ​ 
t
  =  ​  ​    ​ ​ ​ ​
∂ ​ε​ t​ ​ ⎪​ψ​____
∂ ​r​ t​ ∂ ​r​ t+j​
t​  m   ​ + ​∑ k−1j=0​   ____
​  m ​      for k  =  1, 2, …
⎩ ∂ ​ε​ t​ ​ ∂ ​ε​ t​ ​
for ​k  =  0, 1, 2, …​.Thus, and as discussed above, the initial impact on the bubble,
captured by coefficient ​ψ ​ t​​​ , is indeterminate, both in sign and size. Yet, and condi-
tional on ​∂ ​r​ t+k​ /  ∂ ​ε​ m
t 
​ 
​ >  0​ , for ​k  =  0, 1, 2, . ..​  the subsequent growth of the bubble
is predicted to be positive. The long run impact of the monetary policy shock on
the size of the bubble, ​l​im​  k →∞​   ∂ ​q​ tB+k
  ​ 
 /  ∂ ​ε​ m
t​ ​​will be positive or negative depending on
whether the persistence of the real interest rate response is more than sufficient to
offset any eventual negative initial impact. Thus, when considered in combination
with the predicted response of the fundamental component, the theory of rational
bubbles implies that the sign of the response of observed asset prices to a tightening
of monetary policy is ambiguous. Most importantly, however, the theory opens the
door to the possibility that the observed asset price rises (possibly after some initial
decline), as long as one or more of the following conditions are satisfied:

• ​​ψ​t​​is not “too negative,”

• the response of the real interest rate is persistent enough, and
• the relative size of the bubble ​​γ​ t​​is large enough (so that the eventual posi-
tive response of the latter more than offsets the likely decline in the funda-
mental component).
Vol.7 No.1 Galí and Gambetti: Monetary Policy and Bubbles 239

2
Asset price response

−2

Gamma = 0
−4 Gamma = 0.5, psi = 0
Gamma = 0.5, psi = −8
Gamma = 0.5, psi = 6

−6
0 5 10 15 20
Periods after shock

Figure 1. Asset Price Response to an Exogenous Interest Rate Increase: Alternative Calibrations

To illustrate the previous discussion, consider an asset whose dividends are

exogenous and independent of monetary policy. In response to an exogenous pol-
icy tightening the real interest rate is assumed to evolve according to ​∂ ​r​ t+k​ /  ∂ ​ε​ m t​ ​ 
=  ​ρ​ kr​ ​ ,for ​k  =  0, 1, 2, …​The response of the (log) asset price to a unit shock is then
given by:

∂ ​q​ ​ ​ρ ​r​ 
​+ ​γ​ t−1​(​ψt​​ + ​____ ​)​​.
1 − ​ρ​ r​ 
k
____
​  t+k   =  −(1 − ​γ​ t−1​)______
k
m ​
  ​           
∂ ​ε​ t​ ​ 1 − Λ​ρr​​ 1 − ​ρr​​

Figure 1 displays the dynamic responses of the asset price for alternative config-
urations of γ ​ ​and ψ ​   =  0.99​and ​​ρ​r​  =  0.8​. The black line
​ ​. In all cases we assume Λ
(with circles) displays the asset price response in the absence of a bubble (​​γ​ t−1​  =  0​).
The asset price declines on impact, and gradually returns to its original value. The
line with circles shows the response for ​​γ ​t​  =  0.5​ and ​​ψt​​  =  0​. Note that the asset
price also declines on impact, but now it recovers at a faster pace (due to the grow-
ing bubble) and ends up overshooting permanently its initial value and stabilizing
at a higher level. The line with squares corresponds to the case of ​​γ ​t​  =  0.5​ and​​
ψ​t​  =  −8​. Now the negative impact of the interest rate hike on the asset price is
larger, due to its initial shrinking effect on the size of the bubble. Finally, the line
with triangles shows the response under ​​γ ​t​  =  0.5​and ​​ψ​t​  =  6​. Now the asset price
already rises from the time of the shock, given that the positive response of the bub-
ble on impact more than offsets the decline of the fundamental component.
The previous simulations make clear that the theory of rational bubbles is con-
sistent with a broad range of responses of asset prices to a tightening of monetary
policy. By contrast, the conventional view predicts an unambiguous decline in asset
240 American Economic Journal: macroeconomics January 2015

prices, for both the fundamental and bubble components are expected to go down
in response to a policy tightening. Accordingly, any evidence of a decline in asset
prices in response to that tightening would not be conclusive as to the validity of
the two views on the effects of monetary policy on the bubble. On the other hand,
any evidence of a positive impact on the asset price at some horizon subsequent to
the same policy intervention would be clearly at odds with both the key premise and
the implications of the “conventional view,” while consistent (at least, qualitatively)
with the theory of rational bubbles.

II.  The Empirical Model

The present section describes our empirical model, which consists of a structural
vector autoregression model with time-varying coefficients (TVC-SVAR). Beyond
the usual concern for possible structural changes over the sample period considered,
our main motivation for using a model with time-varying coefficients has to do with
the dependence of the stock price response on the relative size of its (eventual) bub-
ble component, which is likely to change over time.
Though focusing on different variables, the specification of our reduced form
time-varying VAR follows closely that in Primiceri (2005). On the other hand our
choice of variables and identification strategy follows that in CEE. Our constant
coefficients VAR, for which we also report results below, can be seen as a limiting
case of the model with time-varying coefficients, so we do not provide a separate
description.
Let ​​yt​​​ , ​​pt​​​ , ​​p​ ct​ ​​ , ​​it​​​ , ​​qt​​​ , and ​​d​ t​​denote, respectively, (log) output, the (log) price level,
the (log) commodity price index, the short-term nominal interest rate controlled by
the central bank, the (log) stock price index, and its corresponding (log) dividend
series (both in real terms). We define ​​xt​​  ≡  [Δ​yt​​, Δ​d​ t​, Δ​pt​​, Δ​p​ ct​ ​​ , ​​i​t​, Δ​qt​​] ′​​.  The rela-
tionship between those variables and the structural shocks is assumed to take the
form of an autoregressive model with time-varying coefficients:

(13) ​​xt​​  =  ​A0​, t​ + ​A1​, t​x​t−1​ + ​A2​, t​x​t−2​ + ⋯ + ​A​ p, t​ x​t−p​ + ​ut​​​,

where ​​A​0, t​​ is a vector of time-varying intercepts, and ​​A​i, t​​ , for ​i  =  1, … , p,​ are
matrices of time-varying coefficients, and where the vector of reduced form innovations​​
u​t​​follows a white noise Gaussian process with mean zero and covariance matrix ​​Σt​​​.
We assume the reduced form innovations are a linear transformation of the underlying
structural shocks ​​ε​t​​given by

​​u​t​  ≡  ​St​​ε​t​​,

where ​E{​εt ​​ε′ ​t​  }  =  I​and ​E{​εt​​ ε​′ t−k​}   =  0​for all ​t​and ​k  =  1, 2, 3, … .​and ​​St​​​is such
that ​​S​t ​S′ 
​t​   =  ​Σt​​​.
Let ​​θt​​  =  vec(​A′t​ ​)​ where ​A ​ ​t​  =  [​A0, t
​ ​, ​A1, t
​ ​…, ​A ​p, t​]​ and v​ ec( · )​ is the column
stacking operator. We assume ​​θ​t​​evolves over time according to the process

(14) ​​θt​​  =  ​θt−1

​ ​ + ​ωt​​​
Vol.7 No.1 Galí and Gambetti: Monetary Policy and Bubbles 241

where ​​ωt​​​is a Gaussian white noise process with zero mean and constant covariance​
Ω​ , and independent of ​​ut​​​at all leads and lags.
We model the time variation of ​Σ ​ t​​​as follows. Let ​Σ ​ ​t​  =  ​Ft​​Dt​​F′ 
t​​​  , where ​​F​t​​is lower
triangular, with ones on the main diagonal, and ​​D​t​​a diagonal matrix. Let ​​σt​​​be the
vector containing the diagonal elements of ​D t​  ​​ and ​​ϕi, t
​ ​ 1/2 ​ ​​ a column vector with the
nonzero elements of the ​(i + 1)​-th row of ​F ​  ​−1
t  
​ ​
​ with ​
i   =  1, …, 5​. We assume that

(15) ​log  ​σt​​  =  log  ​σt−1

​ ​ + ​ζt​​​

(16) ​​ϕi​, t​  =  ​ϕi, t−1

​ ​ + ​νi, t
​ ​​,

where ​​ζ​t​​and ​​ν​i, t​​are white noise Gaussian processes with zero mean and (constant)
covariance matrices Ξ ​ ​ and ​​Ψi​​​ , respectively. We assume that ​ν ​ ​i, t​​ is independent of​​
ν​ j, t​​ , for ​j  ≠  i​ , and that ​​ωt​​​ , ​​εt​​​ , ​​ζt​​​ and ​​νi​, t​​ (for ​i  =  1, …, 5​) are mutually uncor-
related at all leads and lags. Note that the constant coefficient VAR can be seen as a
limiting case of the previous model with ​Ω  =  0, Ξ  =  0, ​Ψi​​  =  0​.
Our identification of the monetary policy shock is inspired by the strategy pro-
posed by Christiano, Eichenbaum, and Evans (2005). More specifically we assume
that the monetary policy shock does not affect GDP, dividends or inflation contem-
poraneously. In addition, our baseline specification assumes that the central bank
does not respond contemporaneously to innovations in real stock prices.9 Letting
the fifth element in ​​εt​​​ , denoted by ​​ε​ m t​ ​​ , correspond to the monetary policy shock, the
first assumption implies that the fifth column of ​​St​​​has zeros as its first four elements,
while its two remaining elements are unrestricted. The second assumption implies
that the last element in the fifth row of ​S ​ ​t​​ is zero. Since our focus is on monetary
policy shocks, we need not place any other restrictions on matrix ​​St​​​. To facilitate
implementation we just let ​​St​​​ be the Cholesky factor of ​​Σ​t​​ , i.e., ​​S​t​  =  ​Ft​​D​ 1/2 t​  ​​ , but
make no attempt to interpret the remaining “structural” shocks.
To define the impulse response functions let us rewrite (13) in companion form:

​x̃  t​​​  =  ​μ̃ ​t ​ + ​​Ã ​t​ ​ x ̃ t​−1​ + ​​ũ t​ ​​,

where ​x̃  t​​​  ≡  [​x′ 

t​​,  ​x′ 
t​−1​,  …, ​x′   ′​​ ,  ​ũ t​​ ​  ≡  [​u′ 
t​−p+1​]  t​​,  0, …, 0​] ​, ​​μ̃ ​t ​  ≡  [​A′ 
′ ̃
0​, t​,  0, …, 0​] ​​ and ​A ​t​ ​​
′
is the corresponding companion matrix. We use a local approximation of the implied
dynamic response to a ​t​period shock. Formally, the local response is given by

∂ ​x​ ​
____ ​  =  ​[​​Ã ​ ​t​ ​]​​6, 6​  ≡  ​Bt, k
​  t+k    ​ ​​
k

∂ ​u′ t​​ 
for ​k  =  1, 2, . .​ where ​​[M]​6, 6​​ represents the first six rows and six columns of any
matrix ​M​ , and where ​​B​t, 0​  ≡  I​. Thus, the dynamic responses of the variables in ​​x​t​​to
a monetary policy shock ​​ε​ m t​ ​​hitting the economy at time ​t​are given by

9 
That assumption is consistent with the evidence reported in Fuhrer and Tootell (2008), based on the estimates
of empirical Taylor rules augmented with stock price changes. Below we discuss the implications of relaxing that
assumption. 
242 American Economic Journal: macroeconomics January 2015

∂   ​x​ ​ ____
____ ∂ ​x​ ​___∂   ​u​​
​  t+k ​   =  ​  t+k   
  ​  
​  t    
​
∂ ​ε​ m
t​ ​ ∂ ​u′t​ ​ ∂ ​ε​ m
t​ ​

=  ​Bt, k
​ ​S​ (5)
t​  ​  ≡  ​Ct​, k​

for ​k  =  0, 1, 2, …​ and where ​​S​ (5) t​  ​​denotes the fifth column of ​​S​t​​. In the case of the
­constant coefficients model the response is just given by ​∂ ​x​t+k​ /  ∂ ​ε​ m t​ ​  =  ​B​k ​S​  ​  ≡  ​Ck​​​ ,
(5)

where ​B​ k​​  ≡  [​ ​Ã ​​ ]​ 6​​, 6​​ .

k

We use Bayesian methods in order to estimate the model with time-varying coef-
ficients. The goal of our estimation is to characterize the joint posterior distribution
of the parameters of the model. To do that we use, following Primiceri (2005), the
Gibbs sampling algorithm described in the online Appendix.

A. Relation with the Existing Literature

We are not the first to analyze empirically the impact of monetary policy changes
on stock prices.
Patelis (1997) analyzes the role played by monetary and financial variables in
predicting stock returns. He finds that increases in the federal funds rate have a
significant negative impact on predicted stock returns in the short run, but a posi-
tive one at longer horizons. That predictability works largely through the effect of
federal funds rate changes on anticipated excess returns down the road, rather than
dividends or expected returns.
Bernanke and Kuttner (2005) use an event-study approach, based on daily changes
observed on monetary policy decision dates, to uncover the effects on stock prices of
unanticipated changes in the federal funds rate. They find that a surprise 25-basis-
point cut in the federal funds rate is associated with about a 1 percent increase in
stock prices. Their analysis largely attributes that response to a persistent decline in
the equity premium, and to a lesser extent of the relevant cash flows. They do not
report, however, the dynamic response of stock prices to the monetary policy sur-
prise. Rigobon and Sack (2004) obtain similar (but slightly larger) estimates of the
response of stock prices to changes in interest rates using a heteroskedasticity-based
estimator that exploits the increase in the volatility of interest rates on Federal Open
Market Committee (FOMC) meeting and Humphrey-Hawkins testimony dates in
order to control for possible reverse causality.
Gürkaynak, Sack, and Swanson (2005) use intraday data to estimate the response
of asset prices to two factors associated with FOMC decisions. The first factor corre-
sponds, like in Bernanke and Kuttner (2005), to the unanticipated movements in the
federal funds rate target. The estimated effect on stock prices is very similar to that
uncovered by Bernanke and Kuttner (2005).10 The second factor is associated with
revisions in expectations about future rates, given the funds rate target, and appears
to be linked to the statement accompanying the FOMC decision. The impact of this

10 
Similar results are obtained by D’Amico and Farka (2011) in their first-step, which involves the same
­intraday-data strategy as Gürkaynak, Sack, and Swanson (2005). 
Vol.7 No.1 Galí and Gambetti: Monetary Policy and Bubbles 243

second factor on stock prices is significant, but more muted than the first, possibly
due to revisions in expectations on output and inflation which may partly offset the
impact of anticipated changes in interest rates.
As far as we know, the literature contains no attempts to uncover the effects of
monetary policy shocks on the bubble component of stock prices. Uncovering those
effects requires that the response of the fundamental component stock prices be
estimated using the estimated joint response of dividends and the real interest rate.

III. Evidence

In this section we report the impulse responses of a number of variables to a

monetary policy shock, generated by our estimated VARs, both with constant and
time-varying coefficients. We use quarterly US time series for GDP and its deflator,
the World Bank commodity price index, the federal funds rate, and the S&P 500
stock price index and the corresponding dividend series (both deflated by the GDP
deflator). Our baseline sample period is 1960Q1–2011Q4. Due to the impact of the
zero lower bound on the behavior of the federal funds rate since 2008 and its likely
influence on our estimates we have also estimated the model ending the sample in
2007Q4 as a robustness check.
Figure 2 displays the estimated responses to a contractionary monetary policy
shock, based on the estimated VAR with constant coefficients. The tightening of
monetary policy leads to a persistent increase in both nominal and real rates, a
decline in GDP and an (eventual) decline in the GDP deflator. The response pattern
for dividends is similar to that of GDP. The stock price index is also seen to decline
in the short run, but it recovers fast subsequently and ends up in slightly positive ter-
ritory (though the confidence bands are too large to reject the absence of a long run
effect). Figure 2, panel G displays the implied response of the “fundamental” com-
ponent of the stock price, computed using (5). Not surprisingly, given the response
of the real rate and dividends), the fundamental stock price is shown to decline
sharply on impact, and to return only gradually to its initial value. Figure 2, panel F
compares the latter with that of the observed price shown earlier.
Note that (4) implies

​  =  ​γ ​t−1​(____
∂ ​ε​ m​ ​)
∂ (​qt​+k​ − ​q​ Ft+k
___________   ​)  ∂ ​q​ B  ​  ____
∂ ​q​ F  ​ 
​    m    ​  t+k m ​ 
  − ​  t+k  ​ 
 ​​.
∂ ​ε​ ​ ​
t ∂ ​ε​ ​ ​ t t

As Figure 2, panel H makes clear, the response of the gap ​q​ t+k
​ ​ − ​q​ Ft+k
  ​​ is positive
and, after one period, increasing, which points to
• the existence of a non-negligible bubble component, and
• a substantial difference between the responses of the bubble and fundamen-
tal components of stock prices to a monetary policy shock.11

11 
In the simple example of a rational bubble considered above (with exogenous dividends and a geometric
response of the real rate) we have:

​  =  ​γ​ t−1​(____ ​)​​ .
∂ (​q​ ​ − ​q​    ​) 
________
F
​ρ​ ​  1 − ​ρ​ r​ 
​+ ​ψt​​ + ​____
k k
  
​​  t+k m  t+k  
∂ ​ε​ t​ ​
​  r     
1 − Λ​ρr​​
    
1 − ​ρr​​
244 American Economic Journal: macroeconomics January 2015

Panel A. Federal funds rate Panel B. Real interest rate

0.8 0.8

0.6 0.6

0.4 0.4

0.2 0.2

0 0

−0.2 −0.2
0 5 10 15 20 0 5 10 15 20

Panel C. GDP Panel D. GDP deflator

0.1 0.3

0 0.2
0.1
−0.1
0
−0.2
−0.1
−0.3
−0.2
−0.4
−0.3
−0.5 −0.4
−0.6 −0.5
0 5 10 15 20 0 5 10 15 20

Figure 2. Estimated Responses to Monetary Policy Shocks: VAR with Constant Coefficients
Panel E. Dividends Panel F. Stock prices
(Continued)
0.2 3
0 2.5
2
−0.2
Figure 3, panels A–F show the impulse responses1.5 of a number of variables to a
−0.4
monetary policy shock, based on our estimated VAR 1 with time-varying coefficients.
−0.6 0.5
The estimated dynamic responses of nominal and real rates, shown in Figure 3, pan-
−0.8 0
els A and B respectively, appear to be relatively −0.5
unchanged over time, though the
−1
former shows substantially greater persistence over −1 the last few years of the sample
−1.2
period (possibly due to the “distortion” created−1.5
by the zero lower bound). Figure 3,
−1.4
panels C and D display the impulse responses of−2GDP and the GDP deflator. In both
0 5 10 15 20 0 5 10 15 20
cases the impulse responses are relatively stable over time, with both GDP and its
deflator displaying a persistent negative decline
Panel G. Fundamental component
after the tightening of monetary
Panel H. Price versus fundamental
policy. Broadly speaking, the same holds true for the response of dividends (shown
in0.5Figure 3 panel E), with the exception of a brief 2 period in the early 1980s, when

the tightening of policy appears to have a positive 1.5 impact on dividends after about
0
three years. 1

−0.5 Our focus is, however, on the changing response of stock prices, displayed
0.5

in Figure 3, panel F. Note that the S&P 500 generally 0 declines on impact, often
−1 −0.5
−1
−1.5Thus, to the extent that a bubble is present to begin with (​​γ ​t−1​  >  0​) and its contemporaneous response to the
−1.5
interest rate innovation is not too negative (​​ψ​​   ≳  0​), the gap between the response of the asset price and its funda-
t
−2 should be positive and increasing over time in response to−2
mental a tightening of monetary policy. 
0 5 10 15 20 0 5 10 15 20
−0.4
−0.3
−0.5 −0.4
−0.6 −0.5
Vol.70No.1 5 10 Galí and
15 Gambetti:
20 Monetary 0Policy and
5 Bubbles
10 15 245
20

Panel E. Dividends Panel F. Stock prices

0.2 3
0 2.5
2
−0.2
1.5
−0.4 1
−0.6 0.5
−0.8 0
−0.5
−1
−1
−1.2 −1.5
−1.4 −2
0 5 10 15 20 0 5 10 15 20

Panel G. Fundamental component Panel H. Price versus fundamental

0.5 2
1.5
0
1

−0.5 0.5
0
−1 −0.5
−1
−1.5
−1.5
−2 −2
0 5 10 15 20 0 5 10 15 20

Figure 2. Estimated Responses to Monetary Policy Shocks: VAR with Constant Coefficients (Continued)

s­ubstantially, in response to an exogenous monetary policy tightening. Until the

late 1970s that decline is persistent, in a way consistent with the response of stock
prices in the absence of a bubble. By contrast, starting in the early 1980s, the ini-
tial decline is rapidly reversed with stock prices rising quickly (and seemingly per-
manently) above their initial value. That phenomenon is particularly acute in the
1980s and 1990s. The previous estimated response stands in contrast with that of
the fundamental component, as implied by the impulse responses of the real rate
and dividends, and shown in Figure 3, panel G. Note that the pattern of the response
of fundamental stock prices to a tightening of monetary policy has changed little
over time, (roughly) corresponding to that obtained with the constant coefficient
VAR. Figure 3, panel H displays the response of the gap between observed and fun-
damental stock prices. Note that with the exception of the early part of the sample
that gap appears to be positive and growing, in a way consistent with the theory of
rational bubbles, and in contrast with the “conventional” view. Figure 4 provides an
alternative perspective to the same evidence, by displaying the evolution over time
of the impact of the monetary policy shock on the log deviations between observed
and fundamental stock prices at different horizons. Figure  5 shows the estimated
(bootstrap-based) probability that the same gap is positive. Note that the probability
is well above 50 percent (and often much closer to unity) since the mid-80s.
246 American Economic Journal: macroeconomics January 2015

Panel A. Federal Funds rate

1.5

0.5

−0.5
20
15 2020
10 2000
5 1980
0 1960

Panel B. Real interest rate

1.5

0.5

−0.5
20
15 2020
10 2000
5 1980
0 1960

Panel C. GDP

0.5

−0.5

−1

−1.5
20
15 2020
10 2000
5 1980
0 1960
Figure 3. Estimated Responses to Monetary Policy Shocks: VAR with Time-Varying Coefficients
(Continued)

Figure 6, panels A–D illustrate the changing patterns of stock price responses
by showing the average impulse responses of both observed and fundamental
prices over four alternative three-year periods: 1967:II–1970:I, 1976:I–1978:IV,
1984:IV–1987:III, and 1997:I–1999:IV. The changing pattern of the gap between
Vol.7 No.1 Galí and Gambetti: Monetary Policy and Bubbles 247

Panel D. GDP deflator

0.5

−0.5

−1
20
15 2020
10 2000
5 1980
0 1960

Panel E. Dividends

−1

−2

−3
20
15 2020
10 2000
5 1980
0 1960

Panel F. Stock prices

6
4
2
0
−2
−4
−6
20
15 2020
10 2000
5 1980
0 1960

Figure 3. Estimated Responses to Monetary Policy Shocks: VAR with Time-Varying Coefficients
(Continued)

the two variables emerges clearly. The response during the first episode, from the
1960s, points to a drop of the observed price larger than that of the fundamental.
The evidence from the 1970s suggests a relatively similar pattern in both responses,
though the observed price displays some overshooting relative to the fundamental.
248 American Economic Journal: macroeconomics January 2015

Panel G. Fundamental component

−1

−2

−3

−4
20
15 2020
10 2000
5 1980
0 1960

Panel H. Price minus fundamental

10

−5
20
15 2020
10 2000
5 1980
0 1960

Figure 3. Estimated Responses to Monetary Policy Shocks: VAR with Time-Varying Coefficients
(Continued)

On the other hand, the estimated responses for the three-year periods before the
crash of October 1987, as well as the period before the burst of the dotcom bubble,
point to a very ­different pattern: the observed price declines less than the fundamen-
tal to begin with, and then recovers faster to end up in strongly positive territory,
as the theory of rational asset price bubbles would predict when a large bubble is
present.
We have reestimated the model using an alternative sample period ending in
2007:III, i.e., leaving out the period associated with the deeper financial crisis, a
binding zero lower bound and the adoption of unconventional monetary policies.
We have also examined the robustness of our results to the use of earnings instead
of dividends. Even though the latter is, in principle, the appropriate variable, earn-
ings are often used in applications due to their less erratic seasonal patterns. In both
cases, our findings are largely unchanged. Figures 7 and 8 illustrate that robustness
Vol.7 No.1 Galí and Gambetti: Monetary Policy and Bubbles 249

0
Impact
1 quarter
1 year
−2 3 years

1970 1975 1980 1985 1990 1995 2000 2005 2010

Figure 4. Estimated Responses of q minus qF at Selected Horizons

0.9

0.8

0.7

0.6

0.5

0.4

0.3 Impact
1 quarter
0.2 1 year
3 years

0.1

1970 1975 1980 1985 1990 1995 2000 2005 2010

Figure 5. Probability of a Positive Response of q minus qF at Selected Horizons

250 American Economic Journal: macroeconomics January 2015

Panel A. 1967:II–1970:I Panel B. 1976:I–1978:IV

8 8

6 6

4 4

2
2
0
0
−2
−2
−4
−4
2 4 6 8 10 12 14 16 18 20 2 4 6 8 10 12 14 16 18 20

Panel C. 1984:IV–1987:III Panel D. 1997:I–1999:IV

8 8

6 6

4 4

2 2

0
0
−2
−2
−4
−4
2 4 6 8 10 12 14 16 18 20 2 4 6 8 10 12 14 16 18 20

Figure 6. Estimated Responses to Monetary Policy Shocks: Analysis of Selected Episodes

by showing the dynamic response of the gap between the stock price and the fun-
damental to an exogenous tightening of monetary policy using, respectively, the
shorter sample period and the earnings-based VAR. Note that the observed pattern
of responses is very similar to that found in Figure 3, panel H, at least qualitatively.

IV.  Alternative Interpretations

A. Time-Varying Equity Premium

The theoretical analysis of Section I has been conducted under the maintained
assumption of risk neutrality or—equivalently, for our purposes—of a constant
expected excess return (or equity premium). That assumption also underlies our
definition of the fundamental component of stock prices and of the estimates of
the latter’s dynamic response to monetary policy shocks shown in the previous
section. There is plenty of evidence in the literature, however, of time-varying
expected excess return in stock prices, partly linked to monetary policy shocks.12
Next we examine whether our estimated deviation between observed stock prices

12 
See, e.g., Thorbecke (1997), Patelis (1997), and Bekaert, Hoerova, and Lo Duca (2013). 
Vol.7 No.1 Galí and Gambetti: Monetary Policy and Bubbles 251

10

−5
20
15 2010
2000
10 1990
5 1980
1970
0 1960

Figure 7. Estimated Responses of q minus qF to Monetary Policy Shocks: Shorter Sample Period

15

10

−5
20
15 2020
10 2000
5 1980
0 1960
F
Figure 8. Estimated Responses of q minus q to Monetary Policy Shocks: Earnings-Based Estimates

and the “measured” fundamental component can be plausibly interpreted as result-

ing from a time-varying equity premium, as an alternative to the bubble-based
interpretation.
Let ​​z​t+1​​ denote the (log-linearized) excess return on stocks held between t​​ and​
t + 1​ , given by

​​z​t+1​  =  Λ​qt+1
​ ​ + (1 − Λ)​d​ t+1​ − ​qt​​ − ​r​ t​​.
252 American Economic Journal: macroeconomics January 2015

In the absence of a bubble, we can write the equilibrium stock price

∞
​​qt​​  =  const + ​ ∑ ​ ​Λ​ k​[(1 − Λ)​E​ t​{​d​ t+k+1​} − ​E​ t​{​r​ t+k​} − ​E​ t​{​zt+k+1
​ ​} ]​​.
k=0

Thus, the dynamic response of the stock price to an exogenous monetary policy
shock is given by

∂ ​d​ t+k+j+1​ _____
∂ ​r​ t+k+j​ _______
∂ ​zt+k+j+1
​ ​
  ​ j​((1 − Λ)​_______ )
∂ ​qt​+k​ ∞
​ ____ m ​   =  ​ ∑ ​​ Λ
    m   ​  
− ​  m     
​ − ​  m    ​  ​​.
∂ ​ε​ t​ ​ j=0 ∂ ε
​  
​
t 
​​ ∂  ε
​ ​
 
t  
​​ ∂ ε
​ ​
 
t  
​​

Then it follows that the gap between the response of the observed price and the
response of the fundamental component computed under the assumption of risk
neutrality are related to the equity premium response according to the equation:

∂ ​q​ ​ ____
∂ ​q​    ​ 
F ∞ ∂ ​z​ ​
____
​  t+k ​ 
 − ​  t+k ​    =  −​ ∑ ​​ Λ
    ​ j_______
​      ​​ 
t+k+j+1

∂ ​ε​ m
t​ ​ ∂ ​ε​ m
t​ ​ j=0 ∂ ​ε​ t​ ​
m

Λ​ j​((1 − Λ)​______
t​ ​ )
∂ ​q​ F  ​  ∂ ​d​ t+k+j+1​ ∂ ​r​ t+k+j​
 ≡ ​∑ j=0  ​ 
∞
for ​k = 0, 1, 2, … ​and where, as above, ____
​ ∂ ​εt+k
​ m
 ​    ∂ ​ε​ m​  ​   − ​ ____
​      
​ ​​
t​ ​ t ∂ ​ε​ m
is the fundamental stock price under risk neutrality.
Thus, an interpretation of the evidence above that abstracts from the possibility of
bubbles and relies instead on a time-varying equity premium requires that the latter
declines substantially and persistently in response to a tightening of monetary condi-
tions. That implication is at odds with the existing evidence on the response of excess
stock returns (e.g., Patelis 1997, and Bernanke and Kuttner 2005); or variables that
should be closely related to it, like the VIX (Bekaert, Hoerova, and Lo Duca 2013).

B. Long-Term Rate Response

The evidence of a positive response of stock prices to a tightening of mone-

tary policy could also be reconciled with a fundamentals-based explanation if the
observed rise in the federal funds rate coexisted with a simultaneous decline in the
long-term interest rate, possibly due to a (mistaken) anticipation of sufficiently
lower short term rates further down the road.13 In order to assess that hypothesis we
have reestimated our VAR with the yield on the ten-year government bond replacing
stock prices. Figure 9 displays the dynamic response of the long-term rate to a tight-
ening of monetary policy (i.e., to an orthogonalized innovation in the federal funds
rate, as above). The figure makes clear that the long-term rate rises persistently in
response to the higher federal funds rate. The increase is particularly large in the
period starting in the early 1980s, precisely when the gap between the observed
stock price and its fundamental value shows a larger increase. Thus, the hypothesis
that the observed rise in stock prices is due to a decline in long-term rates is not
supported by the evidence.

13 
This possibility was suggested by our discussant Lucrezia Reichlin. 
Vol.7 No.1 Galí and Gambetti: Monetary Policy and Bubbles 253

0.6

0.4

0.2

−0. 2
20
15 2020
10 2000
5 1980
0 1960

Figure 9. Estimated Response of Long-Term Rate to Monetary Policy Shocks

C. Simultaneity

The estimates reported above were obtained under the identifying assumption that
the Federal Reserve did not respond contemporaneously (i.e., within the quarter) to
stock price innovations. That assumption is consistent with the “pre-crisis consensus”
according to which central banks should focus exclusively on stabilizing inflation
and the output gap.14
Here we examine the robustness of our findings to relaxing that constraint, by
allowing for some (contemporaneous) simultaneity in the determination of interest
rates and stock prices. More specifically, we reestimate our empirical model under
the assumption that current log change in stock prices enters the interest rate rule
with a coefficient ​0.02​. This implies that, ceteris paribus, a 10 percentage point
increase in stock prices within a quarter triggers a 20 basis points rise in the federal
funds rate. The previous assumption is consistent with the estimated reaction of
monetary policy to the stock market changes obtained by Rigobon and Sack (2003)
using an approach that exploits heteroskedasticity in stock price shocks to identify
the coefficient measuring that reaction.15

14 
It is also consistent with formal evidence in Fuhrer and Tootell (2008) based on estimated interest rate rules
using real time Greenbook forecasts, though that evidence does not rule out the possibility of an indirect response
to stock prices, based on their potential ability to predict output or inflation developments. 
15 
D’Amico and Farka (2011) use an alternative two-step procedure to identify the policy response to stock
prices, obtaining a similar estimate of the response coefficient (about ​0.02​). Furlanetto (2011) revisits de Rigobon-
Sack evidence and concludes that the positive estimated reaction is largely driven by the Fed response to the stock
market crash of 1987. 
254 American Economic Journal: macroeconomics January 2015

Panel A. Stock prices

−2

−4

−6

−8

−10
20
15 2020
10 2000
5 1980
0 1960

Panel B. Prices minus fundamental

−2

−4

−6

−8
20
15 2020
10 2000
5 1980
0 1960

Figure 10. Estimated Responses to Monetary Policy Shocks: Alternative Identification

The estimated responses of interest rates and dividends to a monetary policy

shock (not shown) are not much affected by the use of this alternative identification
scheme. But the same cannot be said for stock prices: with the exception of a brief
period in the early 1980s, the latter now decline persistently throughout the sample
period in response to a tightening of monetary policy, as shown in Figure 10 panel A.
Furthermore, and most importantly for our purposes, the gap between the observed
price and the estimated fundamental price also declines strongly in response to the
same shock, as shown in Figure 10, panel B. The latter response is consistent, at
least in a qualitative sense, with the conventional wisdom regarding the impact of
Vol.7 No.1 Galí and Gambetti: Monetary Policy and Bubbles 255

−2

−4

−6
0

−8
0.01
0.02
0.03
−10

1970 1975 1980 1985 1990 1995 2000 2005 2010

Figure 11. Estimated Response of Stock Prices at a One-Year Horizon:

Alternative Calibrations of Endogenous Policy Response

monetary policy on stock price bubbles, and contrasts starkly with the evidence
based on our baseline specification.
If one accepts this alternative identifying assumption as correct, the findings
obtained in the previous section should be interpreted as spurious, and driven by
biased estimates of matrices ​{​S​ t​}​resulting from the imposition of an incorrect iden-
tifying assumption. Figure 11 displays the stock price response after four quarters
to the tightening of monetary policy, for four alternative calibrations of the contem-
poraneous stock price coefficient in the interest rate rule: ​0.0​ , ​0.01​ , ​0.02​ , and ​0.03​.
We see that estimates of the effects of monetary policy on stock prices are rather
sensitive to the calibration of that parameter. In a nutshell, the larger is the calibrated
stock price coefficient in the interest rate rule, the smaller (i.e., more negative) is the
estimated effect of an interest rate shock on stock prices. That negative conditional
comovement is required in order to compensate for the strong positive comovement
that arises as a result of nonmonetary policy shocks, due to the endogenous policy
response to stock price movements embedded in the rule.
The previous interpretation, however, is subject to an important caveat, which
calls it into question. In a recent paper, Furlanetto (2011) has revisited the evidence
of Rigobon and Sack (2003) using data that extends over a longer sample period
(1988–2007) and focusing on the stability over time in the estimates of the mone-
tary policy response to stock prices.16 He shows that the main finding in Rigobon

16 
In addition, he also examines the evidence for six other economies (Australia, Canada, New Zealand, Norway,
Sweden, and the United Kingdom). He finds evidence of a significant endogenous response to stock prices only in
Australia. 
256 American Economic Journal: macroeconomics January 2015

and Sack (2003) is largely driven by a single episode: the Fed’s interest rate cuts
in response to the stock market crash in 1987. When the same empirical model is
reestimated using post-1988 data, the estimated policy response is much smaller
or insignificant. The Furlanetto evidence has an important implication for the pres-
ent paper, for it suggests that our baseline specification is a good approximation,
possibly with the exception of the period around 1987. Given that our empirical
framework allows the model’s coefficients to vary over time, that “transitory” mis-
specification should not distort the estimated responses for other “segments” of the
sample. On the other hand, imposing a “fixed” stock price coefficient in the interest
rate rule in the absence of an endogenous policy response would likely distort the
estimated model for the entire sample period.
Thus, and conditional on Furlanetto’s findings, our evidence pointing to an even-
tual positive (and growing) response of stock prices (in both levels and deviations
from fundamentals) to a tightening of monetary policy should be viewed as valid,
while the estimates using the alternative specification are likely to be distorted by
the imposition of an identifying assumption that is invalid for much of the sample.

V.  Concluding Remarks

Proposals for a “leaning against the wind” monetary policy in response to per-
ceived deviations of asset prices from fundamentals rely on the assumption that
increases in interest rates will succeed in shrinking the size of an emerging asset
price bubble. Yet, and despite the growing popularity of such proposals, no evidence
seems to be available providing support for that link.
In the present paper we have provided evidence on the response of stock prices to
monetary policy shocks, and tried to use that evidence to evaluate the empirical mer-
its of the “conventional” view according to which the size of the bubble component
of stock prices should decline in response to an exogenous increase in interest rates.
Our evidence is based on an estimated vector-autoregression with time-varying
coefficients, applied to quarterly US data. Under our baseline specification, which
assumes no contemporaneous response of monetary policy to asset prices, the
­evidence points to protracted episodes in which stock prices increase persistently in
response to an exogenous tightening of monetary policy. That response is clearly at
odds with the “conventional” view on the effects of monetary policy on bubbles, as
well as with the predictions of bubbleless models. We also argue that it is unlikely
that such evidence be accounted for by an endogenous response of the equity pre-
mium to the monetary policy shocks or by “mistaken expectations” on the part of
market participants that might drive long-term interest rates down.
The previous findings are overturned when we impose a contemporaneous interest
rate response to stock prices consistent with the evidence in Rigobon and Sack (2003):
under this alternative specification our evidence points to a decline in stock prices
in response to a tightening of monetary policy, beyond that warranted by the esti-
mated response of the fundamental price. Recent independent evidence by Furlanetto
(2011), however, calls into question the relevance of this alternative specification.
Further research seems to be needed to improve our understanding of the effect
of interest rate changes on asset price bubbles. That understanding is a necessary
Vol.7 No.1 Galí and Gambetti: Monetary Policy and Bubbles 257

condition before one starts thinking about how monetary policy should respond to
asset prices. We hope to have contributed to that task by providing some evidence
that calls into question the prevailing dogma among advocates of “leaning against
the wind” policies, namely, that a rise in interest rates will help disinflate an emerg-
ing bubble.

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