The Market Price of Risk and Macro-Financial Dynamics

Abstract

We propose the conditional volatility of GDP spanned by financial factors as a “Volatility Financial Conditions Index” (VFCI) and show its relation to the market price of risk. The VFCI exhibits superior explanatory power for stock and bond risk premia compared to other FCIs. We use a variety of identification strategies and instruments to demonstrate robust causal relationships between the VFCI and macroeconomic aggregates: a tightening of financial conditions as measured by the VFCI leads to a persistent contraction of output and triggers an immediate easing of monetary policy. Conversely, contractionary monetary policy shocks cause tighter financial conditions.