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...
Please join StudyMode to read the full document