Monetary Stability and Stock Returns: A Bivariate Generalized Autoregressive Conditional Heteroscedasticity Modelling Study

Abstract

This paper employs a constant conditional correlation bivariate EGARCH-in-mean model to investigate interactions among the rate of inflation, stock returns and their respective volatilities. This approach is capable of accommodating all the possible causalities among the four variables simultaneously, and therefore could deliver contemporary evidence of the nexus between monetary stability and stock market. The postwar dataset of the US inflation and stock returns is divided into pre- and post- Volcker period and the estimation results show some significant changes of inflation-stock return relation, as well as indirect links between two volatilities. The core findings in this study suggest that promoting monetary stability contributes to more mutual interactions among the four variables, in particular, common stock is a more effective hedge against inflation, and the level of inflation rate is central to explaining the relation between the two volatilities.