International monetary policy and stock market returns

Abstract

The purpose of this thesis is to investigate the importance of macroeconomic factors such as monetary policy and political risk to international financial markets. In the first chapter, I study the welfare and asset pricing implications of monetary policy coordination in a two-country world. The building block is a sticky-price model with the long-run risk in which central banks either coordinate to jointly maximize global welfare or unilaterally optimize local welfare. Limited fiscal capacity leaves some firms unhedged against external risk. Therefore, non-coordinating central banks have the incentive to introduce unexpected deflation which serves as a defence mechanism to sustain the households purchasing power. I find monetary policy coordination can eliminate such deflation and achieve the first-best output levels, leading to welfare improvements equivalent to 1%–3% of steady state consumption. In the second chapter, I generalize the long-run risk model with nominal rigidities to study the asset pricing implications. Qualitatively, I find lower risk premia under coordination but only a small fraction of this effect is passed on to the long-run growth. As a result, the asset pricing changes are quantitatively small as coordination only affects the level of consumption rather than the long-run growth of consumption. In the last chapter, I study the importance of US presidential cycle to the dynamics of international stock returns. When the US president is a Democrat rather than a Republican, I find excess returns are 12% higher and dollar-based currency risk premia are 4.5% lower in a sample of 23 countries. The US trade policy could be a possible explanation for the return difference. When the president is a Democrat, I show that central countries in the trade network exhibit higher stock returns and lower volatilities than peripheral countries.