Financial Frictions and Reaction of Stock Prices to Monetary Policy Shocks

This paper reveals a new theoretical implication of the credit channel of monetary policy: the stock prices of financially more constrained firms are less responsive to monetary policy shocks. In order to study this implication, we use Enron scandal as an exogenous increase in the monitoring cost of the Arthur Andersen clients relative to other firms. We find that Arthur Andersen clients’stock prices have responded about 50 to 60 basis points less than other firms to a 10 basis point surprise reduction in federal funds target rate in the final days of the scandal, which is in line with the new implication of the credit channel. Moreover, this effect is particularly strong among firms with no ratings, high R&D spending, and positive accruals, likely reflecting that a reliable financial statement is a more important monitoring tool for opaque firms.