Monetary Policy and the stock market  

Monetary Policy matters in fixing or influencing the prices in the economy. If more money is supplied, other things remaining the same, prices will go up, but not equally, or not proportionately. If variables like gross domestic product (GDP), investment and other economic activities grow in the economy, prices may not go up. The increased economic activities will absorb increased money supply in that case.

The money supply, increasing or decreasing, is given effect by the central monetary authority which is empowered to issue money and supply the same to the economy. The Bangladesh Bank (BB), the monetary authority in the country, is, to a large extent, independent of government in discharging its functions. In effecting money supply, BB wants to attain certain objectives, the most important one of which is to maintain price stability. It also wants to see that the users can use the money cheaply or at a lower cost which is reflected through interest rates.

Monetary Policy plays a role in determining interest rates at the desired levels. Monetary Policy does not set the interest rates directly but influences the same. The actual interest rates are determined by the demand for & supply of money. The instruments which are used by the Bangladesh Bank are the repurchase agreements (repos) & reverse repurchase agreements (reverse repos) of treasury bills which the commercial banks and the financial intermediaries buy from and sell to the Bangladesh Bank.  The rate of repos & reverse repos are called policy instruments, and the Bangladesh Bank raises them when it wants to reduce the money supply in the economy, and does the reverse when it wants to make more money available in the economy. By raising or lowering the rates of repos & reverse repos the Bangladesh Bank make money costlier or cheaper depending on its policy objectives.

The interest rate is the most important variable in the financial markets. When it goes up, money becomes more costly; and when it goes down money becomes cheaper. With low interest rates, the borrowers borrow more; when the same goes up, they borrow less. These are the phenomena during normal times. When the economy slows down, people borrow even less at the lower interest rate.

Bangladesh Bank cannot alone fix the interest rates in the marketplace. Interest rates depend on a variety of other factors. What the Bangladesh Bank can do is to control its high-powered money. When the high-powered money gets multiplied by the money multiplier then it makes the total supply of money in the economy.

The Bangladesh Bank broadly measures the money supply by using the monetary aggregate M2 - the measurement of the broad money supply. The monetary aggregate M2 consists of M1 or narrow money, plus the term deposits in the financial market. M1 consists of cash at hand and money in the current accounts with the banks.

The Bangladesh Bank sees the movement M2, and accordingly, gives effect to increasing or decreasing the high-powered money by using its policy instruments. For increasing or decreasing money supply the Bangladesh Bank also uses one kind of auction market which is called open market operation. It decides, if and when, open market operation will take place and accordingly notifies the listed participants.

 Interest rate is the price of borrowing. Banks borrow money from the owners of money at interest rates and sell the same money as credit to their clients against interest rates. The differences between these two rates are called interest spreads. These are said to be too high in Bangladesh for varying reasons like defaulted loans. When one interest rate goes up, the other interest rate also goes up, just like the way prices behave in an intermingling way.

If interest rates go up, the demand for investment fund goes down, and vice-versa. It also happens in the stock market. If the interest rates go up against the borrowing on margins the speculative stock investors will invest less in their margin accounts. Many investors will fall short of margin requirements, i.e., fail to supply additional matching funds as asked by the brokerages. In that case, the brokerages sell the stocks from the investors' margin accounts, and that action may trigger a fall in the stock prices in the stock market.

Also, when interest rates go up in the money market, the opportunity cost of money use shifts away in favour of money market from capital market, that is, more investors take away the money from investment in stocks to other types of investments, including term deposits with the banks. If that happens, the prices of stocks are expected to fall. Prices of anything, be that of a commodity in a commodity market or that of a stock in a stock market, depends on the supply of money in the concerned market. For any reason, if money goes out of stock market, stocks prices will go down. The opportunity cost of use of money is important. If money finds better returns elsewhere in the economy, including that in the terms deposits with banks, money will move there.

So, it is not true that Monetary Policy does not matter in stocks' movement, whether upward or downward. In fact, Monetary Policy matters very much in influencing the investors' decision whether they would buy more stocks or not.

Abu Ahmed is Professor of Economics at the

University of Dhaka.

[email protected]