Abstract
The paper introduces the concept of covariance decomposition in a vector autoregression system. It is applied to the negative relationship between real stock returns and inflation in the postwar United States, and examine whether monetary policy accounts for the negative covariance. When the Federal funds rate is used to identify changes in monetary policy, for the 1959–1990 sample, about 30% of the observed negative covariance is attributable to monetary shocks.
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