This paper was my master's thesis paper at University of Wisconsin - Madison.
The objective of this paper is to address the issue of simultaneity between monetary policy action and contemporaneous stock market returns, to estimate the magnitude of causality. This paper makes inference from a structural vector autoregression (SVAR) model which includes variables for monetary policy and stock returns. External instruments are used for identification; I use the information in the volatility index (VXO) of the Chicago Board Options Exchange, to instrument for stock market returns, in a monetary policy rule. This identifies the response of monetary policy to contemporaneous stock returns. Next, the structural (monetary) shock estimates obtained in the previous equation are used as external instruments for the monetary policy variable, to identify the response of stock prices to monetary policy actions. These two estimates are then imposed in a structural VAR with short run restrictions, to estimate the relationship between the federal funds rate, stock prices, and other macroeconomic variables. I find a significant negative relationship between tightening of policy rate and stock price movement in the short run.