Subjective Beliefs, Monetary Policy, and Stock Price Volatility

Abstract

The main purpose of this study is to understand how the stance of monetary policy affects stock price volatility in a New Keynesian model with investors who have subjective beliefs about stock price growth. I assume that investors construct subjective beliefs about expected capital gains from stock prices by Bayesian learning from observed growth rates of stock prices. I design the model so that the effects of the existence of subjective households are minimal, i.e., it affects only stock prices. I nd that higher monetary policy persistence increases stock price volatilities under the interest rate shock because the subjective beliefs imply myopic pricing in which near-term pricing kernels (or real interest rates) and near-term dividends matter. This result contrasts with stock pricing under the rational expectation, in which future discounted dividends matter.