Structural vector autoregressions (VARs) are widely used to trace out the effect of monetary policy innovations on the economy.However, the sparse information sets typically used in these empirical models lead to at least two potential problems with the results.First, to the extent that central banks and the private sector have information not reflected in the VAR, the measurement of policy innovations is likely to be contaminated.A second problem is that impulse responses can be observed only for the included variables, which generally constitute only a small subset of the variables that the researcher and policymaker care about.In this paper we investigate one potential solution to this limited information problem, which combines the standard structural VAR analysis with recent developments in factor analysis for large data sets.We find that the information that our factor-augmented VAR (FAVAR) methodology exploits is indeed important to properly identify the monetary transmission mechanism.Overall, our results provide a comprehensive and coherent picture of the effect of monetary policy on the economy.

ABSTRACT This paper analyzes the impact of changes in monetary policy on equity prices, with the objectives of both measuring the average reaction of the stock market and understanding the economic sources of that reaction. We find that, on average, a hypothetical unanticipated 25‐basis‐point cut in the Federal funds rate target is associated with about a 1% increase in broad stock indexes. Adapting a methodology due to Campbell and Ammer, we find that the effects of unanticipated monetary policy actions on expected excess returns account for the largest part of the response of stock prices.