Monetary Shocks and Stock Returns: Identification Through the Impossible Trinity

Abstract

We present evidence of significant bias in event studies that investigate the effect of U.S. monetary policy on U.S. stock prices. To overcome this bias, we propose a new identification method based on the Impossible Trinity theory which argues that an economy with a fixed exchange rate and free capital flow cannot have an independent monetary policy. As an application of this method, we study U.S. monetary policy changes as exogenous shocks to the Hong Kong stock market. We find that a 1% (100bp) surprise decrease in the federal funds target rate increases stock prices by about 5%.