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Stock-Bond Return Correlation, Bond Risk Premium Fundamentals, and Fiscal-Monetary Policy Regime

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  • Erica X.N. Li
  • Tao Zha
  • Ji Zhang
  • Hao Zhou

Abstract

We incorporate regime switching between monetary and fiscal policies in a general equilibrium model to explain three stylized facts: (1) the positive stock-bond return correlation from 1971 to 2000 and the negative one after 2000, (2) the negative correlation between consumption and inflation from 1971 to 2000 and the positive one after 2000, and (3) the coexistence of positive bond risk premiums and the negative stock-bond return correlation. We show that two distinctive shocks—the technology and investment shocks—drive positive and negative stock-bond return correlations under two policy regimes, but positive bond risk premiums are driven by the same technology shock.

Suggested Citation

  • Erica X.N. Li & Tao Zha & Ji Zhang & Hao Zhou, 2020. "Stock-Bond Return Correlation, Bond Risk Premium Fundamentals, and Fiscal-Monetary Policy Regime," FRB Atlanta Working Paper 2020-19, Federal Reserve Bank of Atlanta.
    • Handle: RePEc:fip:fedawp:89451
    DOI: 10.29338/wp2020-19
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    More about this item

    Keywords

    stock-bond return correlation; consumption-inflation correlation; fiscal-monetary policy regime; bond risk premiums; technology shocks; investment shocks;
    All these keywords.

    JEL classification:

    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy; Modern Monetary Theory
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation

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