Question

Discuss the mechanisms through which monetary policy affects stock prices and aggregate demand. Please be specific about the channels/theories.

Answer 1

Affect on aggregate demand

Monetary policy affects interest rates and the available quantity of loanable funds, which in turn affects several components of aggregate demand. Tight or contractionary monetary policy that leads to higher interest rates and a reduced quantity of loanable funds will reduce two components of aggregate demand. Business investment will decline because it is less attractive for firms to borrow money, and even firms that have money will notice that, with higher interest rates, it is relatively more attractive to put those funds in a financial investment than to make an investment in physical capital. In addition, higher interest rates will discourage consumer borrowing for big-ticket items like houses and cars. Conversely, loose or expansionary monetary policy that leads to lower interest rates and a higher quantity of loanable funds will tend to increase business investment and consumer borrowing for big-ticket items.

Affect on stock prices

In the current economy, most individuals are directly or indirectly involved in the
stock market. Each day, individual and institutional investors, such as mutual fund
managers and insurance company representatives, invest funds in the stock market. Thus,
to decide which stock to buy or sell, investors need to be able to estimate the expected
rate of return on various stocks and the amount of risk inherent in each stock. On the

other side of the spectrum, business corporations that try to raise capital by offering new
securities to the market need to know how to decide on the price of the new securities.
This research project was designed to study how the investors in the equity market decide
on allocating their investment funds in various stocks—in other words, how they make
choices on what stocks to buy or sell in order to obtain an optimum portfolio of stocks
that maximizes their return and minimizes their risk.
Traditionally, the mandated goal of monetary policy has been price stability and
optimal output and employment in the economy. To achieve this goal, central banks can
manipulate some monetary policy instruments, such as by changing short-term interest
rates and the volume of money supply. However, the effect of monetary policy on the so-
called real economy develops through the broad channel of financial markets, including
the equity market. In fact, monetary policy affects investors’ asset allocation decision
making, and subsequently this effect will be transmitted into the real economy.
Therefore, knowledge of how monetary policy affects the financial market, and more
specifically the equity market, is essential for understanding how monetary policy affects
the broader economy. Because stock prices are highly sensitive to economic conditions
and their values are volatile, this sensitivity can cause large swings in stock prices, lead to
bubbles, and damage the whole economy .
Investors’ decisions on what securities to purchase or sell in the equity market
depend on three factors: (a) changes in the current and future dividends of the company,
(b) changes in short-term interest rates, and (c) the element of risk involved in investing
in a specific asset. The role of central banks and monetary policy implementation is essential for all three factors.