The paper develops a general equilibrium framework that incorporates regime switching between the monetary regime (the M regime) and the fiscal regime (the F regime) to explain three stylized facts:

(1). a positive correlation of stock and bond returns in 1971-2001 and a negative one after 2001;

(2). a negative correlation of consumption and inflation in 1971-2001, and a positive one after 2001;

(3). the coexistence of a positive bond risk premium and a negative correlation of stock and bond returns.

A new Keynesian model was applied with the recursive preference to interactions between monetary and fiscal policies to account for the positive stock-bond return correlation and the negative consumption-growth correlation during 1971-2001 when monetary policy was active and fiscal policy was passive (the M regime), and a sign change of these two correlations after 2001 when monetary policy was passive and fiscal policy was active (the F regime). 

Panel A: Stock-bond return correlation

Panel B: Consumption-inflation correlation

Existing explanations for the sign change of the stock-bond correlation around 2001 focus on the effects of monetary policy. This paper provides an alternative explanation that emphasizes the role of a mix of monetary and fiscal policies. To this end, a general equilibrium framework is developed that incorporates regime switching between the monetary regime (the M regime) and the fiscal regime (the F regime). The findings lay a structural foundation for a general-equilibrium framework that bridges financial markets and monetary-fiscal policies. 

About the Authors:

Zhang Ji, Associate Professor at Tsinghua PBCSF. Zhang's research areas are macroeconomics, monetary policy, fiscal policy, and unemployment theory. Her recent work has appeared in Journal of International Economics and Review of Economics and Statistics and other international first-class journals.

Zhou Hao, the Unigroup Chair Professor of finance at Tsinghua PBCSF. From 2000-2013, he was a senior economist at Federal Reserve Board. Hao’s research agenda covers the areas of variance risk premiums on stock, bond, currency, and credit markets, systemic risk and macro-prudential regulation of financial institutions, China financial markets and reforms. He has published in leading academic journals like Journal of Finance, Review of Financial Studies, Journal of Financial Economic, among others.

Li Xuenan, Associate Professor at CKGSB. Li’s research areas include asset pricing, monetary policy, and corporate governance. Her findings are published in Review of Financial Studies, Journal of Monetary Economics, and Management Sciences. 

Zha Tao, Research Center Executive Director of the Center for Quantitative Economic Research in the research department of the Federal Reserve Bank of Atlanta, Samuel Candler Dobbs Professor of Economics at Emory University. His major fields of study are macroeconomics, financial economics, the Chinese economy, and econometrics.  He has published in many journals, including Review of Economic Studies, Econometrica, American Economic Review, and Journal of Political Economy. Three of his articles were cited by the 2011 Nobel Economic Sciences Prize Committee.