Estimates of the standard deviation of monthly stock returns vary from two to twenty percent per month during the 1857–1987 period. Tests for whether differences this large could be attributable to estimation error strongly reject the hypothesis of constant variance. Large changes in the ex ante volatility of market returns have important negative effects on risk-averse investors. Moreover, changes in the level of market volatility can have important effects on capital investment, consumption, and other business cycle variables. This raises the question of why stock volatility changes so much over time.

Many researchers have studied movements in aggregate stock market volatility. Officer (1973) relates these changes to the volatility of macroeconomic variables. Black (1976) and Christie (1982) argue that financial leverage partly explains this phenomenon. Recently, there have been many attempts to relate changes in stock market volatility to changes in expected returns to stocks, including Merton (1980), Pindyck (1984), Poterba and Summers (1986), French, Schwert, and Stambaugh (1987), Bollerslev, Engle, and Wooldridge (1988), and Abel (1988). Mascaro and Meltzer (1983) and Lauterbach (1989) find that macroeconomic volatility is related to interest rates.

Shiller (1981a,b) argues that the level of stock market volatility is too high relative to the ex post variability of dividends. In present value models such as Shiller's, a change in the volatility of either future cash flows or discount rates causes a change in the volatility of stock returns. There have been many critiques of Shiller's work, notably Kleidon (1986). Nevertheless, the literature on “excess volatility” has not addressed the question of why stock return volatility is higher at some times than at others.

This paper characterizes the changes in stock market volatility through time. In particular, it relates stock market volatility to the time-varying volatility of a variety of economic variables. Relative to the 1857–1987 period, volatility was unusually high from 1929 to 1939 for many economic series, including inflation, money growth, industrial production, and other measures of economic activity. Stock market volatility increases with financial leverage, as predicted by Black and Christie, although this factor explains only a small part of the variation in stock volatility. In addition, interest rate and corporate bond return volatility are correlated with stock return volatility. Finally, stock market volatility increases during recessions. None of these factors, however, plays a dominant role in explaining the behavior of stock volatility over time.

It is useful to think of the stock price,

where ^{1}

At the aggregate level, the value of corporate equity clearly depends on the health of the economy. If discount rates are constant over time in (1), the conditional variance of security prices is proportional to the conditional variance of the expected future cash flows. Thus, it is plausible that a change in the level of uncertainty about future macroeconomic conditions would cause a proportional change in stock return volatility.^{2} If macroeconomic data provide information about the volatility of either future expected cash flows or future discount rates, they can help explain why stock return volatility changes over time. “Fads” or “bubbles” in stock prices would introduce additional sources of volatility.

Section I describes the time series properties of the data and the strategy for modeling time-varying volatility. Section II analyzes the relations of stock and bond return volatility with the volatility of inflation, money growth, and industrial production. Section III studies the relation between stock market volatility and macroeconomic activity. Section IV analyzes the relation between financial leverage and stock return volatility. Section V analyzes the relation between stock market trading activity and volatility. Finally, Section VI synthesizes the results from the preceding sections and presents concluding remarks.