The Effects of Central Bank Policy on the Stock Market: A Dynamic Stochastic General Equilibrium Model

Zoleikha Morsali Arzanagh; Hossein  Valadpour

Authors

Zoleikha Morsali Arzanagh Department of Economics, Ka.C., Islamic Azad University, Karaj, Iran https://orcid.org/0000-0002-0611-029X
Hossein Valadpour Department of Economics, Ta.C., Islamic Azad University, Tabriz, Iran Author https://orcid.org/0009-0005-5168-710X

Keywords:

Central bank policy, stock market, DSGE model, monetary transmission, interbank market, bank lending, Iran

Abstract

This study aimed to develop a New Keynesian dynamic stochastic general equilibrium model to investigate how central bank interest-rate and reserve-requirement policies affect Iran’s stock market through the interest-rate, asset-price, bank-lending, interbank-market, and bank portfolio-allocation channels. The study used a quantitative macroeconomic modeling design based on quarterly data from Iran for 1991Q1–2023Q4. Data were obtained from the Central Bank of the Islamic Republic of Iran, the Statistical Center of Iran, and the Tehran Stock Exchange. The model incorporated households, firms, commercial banks, the interbank market, the stock market, the government, and the central bank, with 42 endogenous variables and seven structural shocks. The series were seasonally adjusted, converted into real terms, logarithmically transformed, and detrended using the Hodrick–Prescott filter with λ=1600. Structural parameters were calibrated using previous Iranian DSGE studies, direct calculations, and simulated moment matching. The nonlinear system was log-linearized around the deterministic steady state, solved under the Blanchard–Kahn conditions, and simulated using Dynare 5.4 in MATLAB R2023a. Model validation was conducted through moment comparison, correlation analysis, impulse-response functions, forecast-error variance decomposition, and sensitivity analysis. A contractionary monetary-policy shock reduced output by a peak of 0.58%, consumption by 0.45%, investment by 0.89%, inflation by 0.34%, stock returns by 1.12%, stock-market volume by 0.96%, and bank lending by 0.71%. In contrast, bank deposits increased by 0.41%, the interbank rate by 0.78%, and the lending rate by 0.65%. Stock returns responded faster than output and investment, confirming the forward-looking nature of asset prices. Monetary-policy shocks explained 31.2% of stock-return variability, 27.8% of trading-volume variability, 24.6% of bank-loan variability, and 38.4% of interbank-rate variability. Sensitivity analysis showed that the direction of the results remained stable across alternative parameter values. Central bank policy significantly influences Iran’s stock market through interconnected valuation, credit, interbank, and banking portfolio channels, with financial-market variables adjusting more rapidly than real-sector variables.

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