Erica X.N. Li, Tao Zha, Ji Zhang, and Hao Zhou
Working Paper 2020-19
October 2020

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Abstract: We incorporate regime switching between monetary and fiscal policies in a general equilibrium model to explain three stylized facts: (1) the positive stock-bond return correlation from 1971 to 2000 and the negative one after 2000, (2) the negative correlation between consumption and inflation from 1971 to 2000 and the positive one after 2000, and (3) the coexistence of positive bond risk premiums and the negative stock-bond return correlation. We show that two distinctive shocks—the technology and investment shocks—drive positive and negative stock-bond return correlations under two policy regimes, but positive bond risk premiums are driven by the same technology shock.

JEL classification: G12, G18, E52, E62

Key words: stock-bond return correlation, consumption-inflation correlation, fiscal-monetary policy regime, bond risk premium, technology shock, investment shock link

The authors thank Hui Chen, Eric Leeper, Yang Liu, Deborah Lucas, Pengfei Wang, and participants in seminars and conferences at Cheung Kong Graduate School of Business, Tsinghua University's People's Bank of China School of Finance, the Massachusetts Institute of Technology's Sloan Business School, the Boston Fed, the Asian Bureau of Finance and Economic Research annual conference, and the Central Bank Research Association annual meeting for helpful comments. The authors also thank Dan Waggoner for his help in programming and Eric Leeper for providing them with the data. This research is supported in part by the National Science Foundation grant number SES 1558486 through the National Bureau of Economic Research. The views expressed here are those of the authors and do not necessarily reflect those of the Federal Reserve Bank of Atlanta, the Federal Reserve System, or the National Bureau of Economic Research. Any remaining errors are the authors' responsibility.

Please address questions regarding content to Erica X.N. Li, Cheung Kong, Graduate School of Business, 1 East Chang An Avenue, Oriental Plaza, Tower, E1-Floor 10, Beijing 100082, China; Tao Zha, Federal Reserve Bank of Atlanta, 1000 Peachtree Street NE, Atlanta, GA 30309-4470 and Emory University and also NBER; Ji Zhang, PBC School of Finance, Tsinghua University, 43 Chengfu Road, Haidian District, Beijing 100083, China; or Hao Zhou, PBC School of Finance, Tsinghua University, 43 Chengfu Road, Haidian District, Beijing, 100083, China.

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