Asset Allocation and Monetary Policy: Evidence from the Eurozone

Abstract

The eurozone has a single short-term nominal interest rate, but monetary policy conditions measured by either real short-term interest rates or Taylor rule residuals varied substantially across countries in the period between 2003-2010. We use this cross-country variation in the (local) tightness of monetary policy conditions to examine its influence on equity and money market flows. In line with a powerful risk-shifting channel, we find that fund investors in countries with lower real interest rates shift their portfolio investment out of the money market and into the riskier equity market. This produces the strongest equity price increase in countries where domestic institutional investors hold a large share of the countries' stock market capitalization.