Question

Assume all policy rates, current and expected into the future had been 2%. Suppose the Fed decides to tighten monetary policy and increase the short-term policy rate (r11) from 2% to 3%

.a)What happens to stock prices if the change in r11?

b)What happens to stock prices if the change in r11is expected o be permanent, that is, is expected to persist?

Answer 1

a. If there is increase in the rate of interest in the economy from 2 per cent to 3 per cent, this will reduce spending by conumers and businesses and this reduction in the demand by businesses will also reduce demand for stocks both by consumers and other businesses and as demand for stock decreases, the stock prices will decrease.

b. If the change is expected to be permanent, then consumers will reduce their spending and businesses will also reduce their spending permanently for a longer period, this will reduce demand for stocks and thus lead to fall in the prices of stocks in the stock market because demand for stocks decreases.