Monetary Policy, Sudden Stops and Stock Market Risk

The raises of the federal funds rate and the US dollar have led to international capital flowing to the United States, and sudden stops events are more likely to occur in emerging economies. Sudden stops are defined as large and current-account reversal events that might cause asset price crashes and recessions. To study the impacts of sudden stops on stock market risk and the stance of monetary policy, we first construct a portfolio theory model with international capital flows. By using the time-varying parameter model, we explore the interaction between sudden stops and stock market risks, as well as the implications of monetary policy on them. We find that the occurrence of sudden stops raises the volatility of the optimal portfolio, which in turn stimulates occurrence of sudden stops, showing a pattern of “spiral rise”. The monetary policy has various effects on the relationship between the two variables for different industries.