Relationship Between Monetary Policy And The Stock Market

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1. Introduction
In the past 20 years, the central banks in most developed countries had successfully managed to control the inflation rate. However, the financial crisis 2008 has highlighted the links between financial market and policy. (Ravn, 2011) The topic I am going to discuss is the relationship between monetary policy and the stock market. What factors have influenced interest rate and how the policymakers should react to the change in stock market have driven the increasing attentions lately. Taylor Rule (2003) will be the core theory used to discuss the model tested. The interpretation of simple Taylor rule is very straightforward. According to the equationi_t=c+β(π_t-π_t^* )+γ(y_t-y_t^* )+ε_t , the policy will be mainly affected by inflation gap and output gap. (Woodford, 2001) The reason why Taylor uses interest rate to represent monetary policy is that the central bank likes to adjust interest rate as a tool to maintain the balance in the market. While, there is a strong debate about the other variables, in particular, stock price volatility. After taking asset price volatility into account, the augmented Taylor rule equation will be reformulated as:i_t=c+β(π_t-π_t^* )+γ(y_t-y_t^* )+∑_(k=1)^n▒〖δ_k s_(t-k)+ε_t 〗. It will influence the monetary policy while the importance of asset price in the market is very controversial. Scholars including Bernanke and Gertler question the importance of asset price in determining the monetary policy and claim that the influence

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