Recent empirical literature documents that unexpected changes in the nominal interest rates have a significant effect on real stock prices: a 25-basis point increase in the nominal interest rate is associated with an immediate decrease in broad real stock indices that may range from 0.6 to 2.2 percent, followed by a gradual decay as real stock prices revert towards their long-run expected value. In this paper, we assess the ability of a general equilibrium New Keynesian asset-pricing model to account for these facts. The model we consider is a production economy with elastic labor supply, staggered price and wage setting, as well as time-varying risk aversion through habit formation. We find that the model predicts a stock market response to policy shocks that matches empirical estimates, both qualitatively and quantitatively. Our findings are robust to a range of variations and parameterizations of the model.
