All About Monetary Policy: Impact on the Stock Market

Monetary Policy as the name itself refers to the policies implemented by the central banks to control the overall supply of money. Monetary policy is a mechanism which is used to promote economic growth with tools like interest rates and changing bank reserve requirements. An economy is maintained by increasing or decreasing the supply of money in the market which fluctuates demand of individuals.

What is Monetary Policy?

To manage the money supply and economic growth, there is a need for economic policies and monetary policy is one of them. Monetary policy is used as a powerful mechanism to regulate the macroeconomic variables such as inflation and unemployment in the economy. Policymakers implement monetary policies with the help of tools like interest rates, purchase and sale of government securities, and managing cash flow in the economy.

Objectives of Monetary Policies

The implementation of monetary policies is aimed at managing inflation, unemployment as well as currency exchange rates.

Inflation

Inflation is the situation when supply of money in the market increases, causing higher flow of money in the market and increasing expenditures in the economy. The supreme objective of monetary policies is to target inflation as it requires it to be kept on low levels. In cases of high level inflation the use of monetary policy can manage the supply of money.

Unemployment

The level of unemployment can be managed with the use of monetary policies by expanding money supply in the market as it would stimulate business activities as well as be helpful in creating job opportunities for people.

Currency Exchange Rates

The central bank regulates the exchange rates between the domestic and foreign currencies. The money supply can be increased by the central bank to issue more currency wherein the domestic currency becomes cheaper in relation to the foreign currency.

Tools to Implement Monetary Policy

But how does monetary policies are implemented in the economy? Central banks influence the money supply by managing interest rates and credit conditions, and the primary tools used to manage the economy are:

Interest Rates Policies

Central banks influence overall economic activity by fluctuating interest rates. A reduction in the interest rates lowers borrowing costs which gives a boost to spending and investment and hence result in enhancing economic growth. An increase in the interest rates restricts spending and investments as the borrowing costs get increased to control inflation.

Repo Rate: The rate at which the central bank lends money to the commercial banks in exchange for securities.

Reverse Repo Rate: The rate at which the central bank borrows money from the commercial banks by selling securities.

Open Market Operations

Government securities are bought and sold in the open market in order to regulate money supply in the economy. To stimulate economic activity, the securities are bought in the open market which results in increasing the money supply and lowering interest rates. On the other hand to cool down the economy, securities are sold which decreases the money supply and raises interest rates.

Reserve Requirements

It is mandatory for the central bank to maintain a minimum amount of reserve balance against the deposits. If the bank lowers the reserve requirements then it results in expanding the money supply because the banks can lend more money. While higher reserve requirements contract the money supply in the market.

Discounted Interest Rates

Discount rate is charged by central banks from commercial banks and other depository institutions for the loans granted to them. Central bank decreases the discount rate to encourage banks to increase their borrowing which would increase money supply in the market and vice versa for the higher discounted rate.

Exchange Rate Interventions

Foreign currencies are bought or sold to influence the exchange rates which stabilize the value of national currency that affects overall economy, inflation as well as trade balance.

Also Read: Fiscal Policy

How do monetary policies affect the stock market?

Monetary policies can have a significant impact on an investor’s portfolio and net worth as any changes in monetary policies affect the operations of financial instruments. Low interest rates or expansionary policies by the central banks will result in encouraging more investments, stock prices will suddenly pick a rally with a decrease in interest rates and hence boost investment and vice versa during contractionary policies. Investors can manage their portfolios as per the implementation of monetary policies according to their risk tolerance and investment horizon.

Importance of Monetary Policy

Monetary plays a crucial role to stabilize overall growth of the economy as it controls the supply of money in the market. Let us explore how important is it for an economy to implement monetary policies:

• Central bank promotes economic growth through interest rates and open market operations which influences overall economic activity of the country.
• Implementing monetary policy aims to influence employment by stimulating investment in the business and increasing consumer spending.
• Monetary policy has a great impact on a country’s exchange rate which affects international trade. Higher interest rates aim to attract foreign investments which appreciate national currency.
• Central banks can stabilize financial systems as they act as a lender of last resort during a financial crisis and hence ensure liquidity in the banking system.

Drawbacks of Monetary Policy

Instead of the advantages that monetary policies offers in an economy, there are also some drawbacks which must be well understood:

Uncertainty

The policies need to be implemented at the right time as the economy is impacted by a number of variable factors which makes it difficult for the policymakers to understand the monetary policies that can stabilize the activities. Moreover, an unforeseen event like financial crisis, natural disasters or geopolitical events disrupts the economic forecasts.

External Influences

Capital inflows and outflows affect the currency which can undermine domestic monetary policy. Economic factors of other countries like recession can also have an impact on the domestic economy according to which monetary policies are required to be altered.

Political Pressures

Political pressures sometimes indulge in the decision making of central banks which leads to complications in implementing the monetary policy. Political interference in the economy or towards the decision making of central banks affect the decisions that lead to changes in policy implementation.

Structural Issues

While implementing monetary policies, structural problems such as labor market rigidities and productivity issues must be monitored. Public and private debt also results in limiting the efficiency of monetary policies.

Fiscal Policy Vs Monetary Policy

Fiscal policy and monetary policy are understood to be the same but both of them are different from each other in many ways:

Basic	Monetary Policy	Fiscal Policy
Objective	Stability of an economy	Growth of an economy
Impact on Exchange Rates	Exchange rates improve when interest rates are high.	No impact on exchange rates.
Controlled By	Central Bank	Ministry of Finance / Government
Measures	It measures the interest rates for lending money in the market.	It measures capital expenditures and taxes of an economy.
Targets	Inflation	No Specific target

Summing it up…

To conclude, monetary policy is a mechanism which is used by the central banks to control inflation by focusing towards the growth of the economy. To maintain smooth movement of the economy, it is necessary to effectively implement fiscal as well as monetary policy.

FAQs