Monetary policy is the use by the Government or central bank ( In Indian Context RBI) of interest rates or controls on the money supply to influence the Economy. The reserve bank of India is the agency which formulates and Implements monetary policy on behalf of the Indian government in an attempt to achieve a set of objectives that are expressed in terms of macroeconomic variables such as the achievement of a desired level or rate of growth in real activity, the exchange rate, the price level or inflation, the balance of payment, real output and employment.
Monetary policy works through the effects of the cost and availability of loans on real activity, and through this on inflation, and on international capital movements and thus on the exchange rate. Its actions such as changes in the RBI discount rate have at best an indirect effect on macroeconomic variables and considerable lags are involved in the policy transmission Mechanism. Monetary policy makes use of various Instruments which include interest rate, reserve requirements (cash requirements or cash ratio and liquidity ratio), selective credit controls, rediscount rate, Treasury bill rate amongst others.
Electronic copy available at: http://ssrn. com/abstract=1743834 When the RBI wants to implement a contractionary monetary policy, it goes to the security market to sell government bonds for money thus decreasing the money stock or the money in circulation in the economy. Contractionary policy is used to combat inflation. Furthermore, monetary policies are described as follows: Accommodative, if the interest rate set by the central monetary authority is intended to create economic growth; Neutral, if it is intended neither to create growth nor combat inflation; or Tight if it is intended to reduce inflation.
Having understood the meaning and types of monetary policy, it becomes expedient to give an explanation of stock markets for better understanding of stock markets’ behaviour and their reaction to monetary policy. Stock market or stock exchange is an institution through which company shares and Government stocks are traded. According to Anyanwu et al (1997), the stock exchange is a market where those who wish to buy or sell shares, stocks, government bonds, debentures, and other securities can do so only through its members (stock brokers).
It is a capital market institution and is essentially a secondary market in that only existing securities, as opposed to new issues, could be traded on. The impact of the stock market on the macroeconomy comes primarily through two channels. The first, as suggested by Greenspan (1996) is that movements in stock prices influence aggregate consumption through the wealth channel. Second, stock price movements also affect the cost of financing to businesses.
A number of macroeconomic and financial variables that influence stock markets have been documented in the empirical literature without a consensus on their appropriateness as regressors. These works include Lanne (2002), Campbell and Yogo (2003), Jansen and Moreira (2004), Donaldson and Maddaloni (2002), Goyal (2004), and Ang and Maddaloni (2005). Frequently cited macroeconomic variables are GDP, price level, industrial production rate, interest rate, exchange rate, current account balance, unemployment rate, fiscal balance, etc.
The nature of the relationship between asset prices movements and monetary policy is currently a hotly debated topic in macroeconomics (Bernanke, 2002). It is of great interest, then, to understand more precisely how monetary policy and the stock markets are related. Monetary policy actions have their most direct and immediate effects on the broader financial markets, including the stock market, government and corporate bond markets, mortgage markets, markets for consumer credit, foreign exchange markets, and many others.
Bernanke (2002) postulated that if all goes as planned, the changes in financial asset prices and returns induced by the actions of monetary policymakers lead to the changes in economic behaviour that the policy was trying to achieve. Thus, understanding how monetary policy affects the broader economy necessarily entails understanding both how policy actions affect key financial markets, as well as how changes in asset prices and returns in these markets in turn affect the behaviour of households, firms, and other decision makers.
Studying these links is an on going enterprise of monetary economists both within and outside the Federal Reserve System. As Bernanke and Kuttner (2005) point out, some observers view the stock market as an independent source of macroeconomic volatility to which policymakers may wish to respond. Monetary policy shifts significantly affect stock returns, thereby supporting the notion of monetary policy transmission via the stock market. Broader financial markets though, for example the stock market, government and corporate bond markets, mortgage markets, foreign exchange markets, are quick to incorporate new information.
Therefore, a more direct and immediate effect of changes in the monetary policy instruments may be identified using financial data. As Blinder (1998) notes, “Monetary policy has important macroeconomic effects only to the extent that it moves financial market prices that really matter—like long-term interest rates, stock market values, and exchange rates. ” Economists such as Cassola and Morana (2004) have observed that monetary policy decisions generally exert an immediate and significant influence on stock index returns and volatilities in both European and US markets.
Their findings also indicate that European Central Bank’s (ECB) press conferences following monetary policy decisions on the same day have defined impacts on European index return volatilities, implying that they convey important information to market participants. Many more assertions and ideas as to the relationship between monetary policy and stock markets abound in the literature and they shall be appropriately examined during the course of this work.
However, there is no consensus opinion as to this topic as economists worldwide are still in debates about the issue. Therefore, this work wishes to address the issue of whether monetary policy affects stock market performance and how monetary policy shocks are transmitted to the stock market. The relationship between monetary policy and stock markets can be viewed in two folds: the effects of monetary policy on stock markets and the effects of stock markets on monetary policy. Economists views and opinions on this issue are divergent.
Considering the issue of the effects of stock markets on monetary policy, the response of asset prices to central bank policy is a key component for analysing the impact of monetary policy on the economy and because of their potential impact on the macroeconomy, stock market movements are likely to be an important determinant of monetary policy decisions. The American stock market crash of October 19, 1987 has made economists examine empirically if monetary policy has been influenced by high valuations of the stock market. Greenspan (2002) stated that central anks should remain focused on achieving price stability and maximum sustainable growth, suggesting that policymakers should respond to stock prices according to their influence on the outlook for output and inflation. On the other hand, in examining the impacts of monetary policy on stock markets, establishing quantitatively the existence of a stock market response to monetary policy changes will not only be germane to the study of stock market determinants; but will also contribute to a deeper understanding of the conduct of monetary policy, and of the potential economic impact of policy actions or inactions.
While economists agree that monetary policy should take stock prices into account as large swings in stock prices, either related or unrelated to fundamentals, may have a destabilizing impact on the economy; they nonetheless disagree on the ways they should do it. Identifying the link between monetary policy and financial asset prices is highly important to gain a better insight in the transmission mechanism of monetary policy, since changes in asset prices play a key role in several channels.
Therefore, it would be important to determine how contractinary or expansionary; accommodative, neutral or tight monetary policy affects the performance of the stock markets of various countries and whether there are any well defined systems for implementing monetary policy that would lead to better stock market performance all around the world.
This project seeks to answer the questions “What are the effects of monetary policy on stock market performance? ”; “How do shocks in the growth rate of market capitalization, money supply growth, lending rate and inflation rate affect the performance of stock markets in both developing and developed countries? The linkage between monetary policy decisions and stock markets’ performance is an important topic for several reasons.
There is a wide consensus among investors and researchers (Bernanke and Kuttner, 2005); (Ioannidis and Kontonikos, 2006) that having reliable estimates of the reaction of asset prices to the policy instrument is important since it makes it easier for economists and central bankers to understand the function, and to assess the effectiveness of stock market channels for monetary policy transmission. Availability of such estimates helps to formulate effective policy decisions.