Monetary Policy

Topics: Monetary policy, Central bank, Economics Pages: 13 (4430 words) Published: June 19, 2013
INTRODUCTION TO THE STUDY
According to the Oxford Dictionary of Economics, monetary policy is the use by the government or central bank of interest rates or controls on the money supply to influence the economy. The Central Bank of every country is the agency which formulates and implements monetary policy on behalf of the 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 central bank discount rate have at best an indirect effect on macroeconomic variables and considerable lags are involved in the policy transmission mechanism. According to Bernanke (2004), the monetary policy goals of the Federal Reserve Bank (the Central Bank of the United States), as often stated in publications and testimony of Federal Reserve Bank (Fed) officials, are “price stability” and “sustainable economic growth”. Recently Federal Reserve officials and academic economists have addressed the question of whether, in addition to price level stability, a central bank should also consider the stability of assets prices. 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 Monetary policy is referred to as either being an expansionary policy, or a contractionary policy. An expansionary policy increases the total supply of money in the economy rapidly or decreases the interest rate. When the central bank wants to carry out an expansionary monetary policy, it goes to the security market to buy government bonds with money, thus increasing the money stock or the money in circulation in the economy. Expansionary policy is traditionally used to combat unemployment in a recession. A contractionary policy on the other hand decreases the total money supply or increases it only slowly, or raises the interest rate. When the central bank 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.

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