Trending and predicting movements of economic indicators - Dissertation Example

Trending and predicting movements of economic indicators Research on monetary policy and their effect on stock market are important as it will explain the purpose of monetary policy in promoting price stability and moderate interest rates. Determining the impact of monetary policy to stock market will enable market analyst to predict stock movements. Trending and predicting movements of economic indicators will enable market analyst to determine foreign exchange trends. For economic planners it is imperative to model the optimum monetary policy to ensure that there is economic stability. And for bankers and financial managers who wants to exercise prudence and responsible banking it would be wise to work with monetary authorities to ensure that the monetary policy is supported unequivocally. Money or currency is the government of the country’s commitment to its holder that the money can be traded in exchange for goods in the country. Meanwhile the true value of money is dependent on several factors such as the actual value of the goods that can be bought by the money or its value as compared with other currencies. However, given that these factors are also dependent on other economic indicators such as inflation and the volume of foreign currency reserve a country has, the correlation of the monetary policy of a country with its interest rates, stock market performance, and inflation will be explored by this paper. Monetary policy is implemented by increasing or decreasing the interest rates that is in theory would be able to inversely increase or decrease the supply of currency in circulation. In fine the monetary policy of a country controls the amount or volume of currency in circulation to stimulate growth or maintain the stability of its economy. The primary onus of a government’s monetary authority is to create the optimal monetary policy that will stabilize prices for its basic commodities and encourage investment. The trick however is how to make banks and other financial institutions follow the interest rates the government’s monetary authority’s desires. One financial instrument that is normally used by governments is the issuance of treasury bills or government bonds wherein the earning interest rates will generally be followed by the banks of that country. By using the interest rates that will define the treasury-bill holder’s earnings will slowly influence the financial market to adjust its interest rates. In the absence of other economic indicators the treasury-bill interest rates will not only be adopted by the banks in their own financial transactions but it will also be used as the bench mark for the amount of money that will be available to borrowers. In theory, if the interest rates are low more people will borrow money from the banks. If the interest rates are high the theory sustains that little no borrower will loan money from the banks and most economic activity will be financed from in-house sources. Other instruments or means of conducting monetary policy includes making the government as the lender of last resort wherein the government will be the source of funds that will be available to borrowers normally banks and other financial institutions. Another means of conducting monetary policy includes changing the reserve requirements in banks in order for them to operate. Another is where the government announces its intent to reduce or control inflation or by simply indicating the interest rates it wants for the money it intends to loan out. And last but not the least is moral suasions or influencing financial institutions about their operating onuses. This paper was primarily completed using secondary sources and some data made available by the professor. The support and anchor of this paper rests on the theories propounded in the literature review. Literature Review This research is inspired by the Taylor rule which was expounded by its creator John Brian Taylor an American economist who proposed that the monetary policy as driven by interest rates should take into consideration inflation, the gross domestic products and other economic conditions. He further stipulated that the Taylor principle will not only foster price stability but also stimulate industries to create more employment “In the late 1970s and early 1980s, John Taylor and a few others demonstrated that real-world rigidities, such as staggered wage and price setting, create an important role for stabilization policy even in economies where households and firms are forward-looking in their decision making and intelligent in forming their expectations. Taylor pioneered new ways of thinking about policy in such economies, showing how central banks can improve economic performance by adjusting short-term lending rates in response to resource slack and inflation. As the idea spread, financial analysts soon started writing newsletters to their clients about it. Policy makers started talking about it as they debated what to do next. Central banks in other countries began to apply it. Academics began to modify and refine it. People started calling it the Taylor rule. And before the 1990s were over, economists were able to show convincingly that policy decisions were remarkably close to it during periods of good economic performance and not so close to it during periods of poor economic performance. John Taylor's approach to macroeconomics and monetary policy has grown in popularity to the point that it has become dominant inside and outside the Federal Reserve System. It has also stimulated new research in the nuts and bolts of how labor and product markets work” (Koenig, et al., 2012). The influx of economists who are still at odds whether to debunk or support John Maynard keynes who viewed economic instability as directly resulting from policy ineptness have found new concepts and principles that is more akin to human nature and the natural order of things in an economic sense. Economic pundits have taken rational expectations as the primary motivation in economic activities if the public percieves that his needs will be satisfied by a particular actions he will gravitate towards that act. Simply put it is now the market that defines the economic condition and not the policy makers. The policy makers simply have to ensure that the policy it crafts or even the policy it implements responds in kind if not in support of the rational expectation of the market (Mishkin, 2009). “The need for a framework that can help us understand the links between monetary policy and the agregate performance of an economy seems self evident. On the one hand, citizens of modern societies have good reason to care about development in inflation, employment, and other economy wide variables, for those development affect to an important degree people’s opportunities to maintain or improve their standard of living. On the other hand, monetary policy, as conducted by monetary authorities has an important role in shaping those macroeconomic levels. Changes in interest rates have direct affect on the valution of financial assets and their expected returns, as well as on the consumption of investments decisions of households and firms” (Gali, 2008). Two seemingly oposing views have influenced this paper to a point where I have chosen two countries that are opposites and may represent the views of each. China’s Renminbi have long thought to be undervalued due to the moneraty policy implemented by its Government. The United States on the other hand is a good example of a free market economy that is not only subject to market forces but also its monetary policy is influenced by the amount of trade being negotiated and consumated within its borders. Victor C. Shih have opined that the Chinese government has a dominant presence in the banking sector to a point where it can intervene in monetary policy at any time to achieve its political and policy objectives. A study of the Chinese financial system indicates a turtle pace activity in reforming the banking sector to conform with international banking standards. However, is this by design or unintentional? (Shih, 2009) The US on the other hand have dominated world trade and in fact the US dollar has been used as a trading standard or the primary currency used in valuating goods. It is in the US where the Taylor rule was crafted mainly because of the steep movement of its stock market during bubbles. A study of the monetary policy of both countries and its implementation will determine the truism and applicability of Taylor’s rule or principle in other economies. It should be noted however that the form of government is different in both countries as well as the cultural and temperament of its population. Thus, the application of Taylor’s rule while designed and have been formed under a democratic economy is a good indicator if its applicability if the cold number of inflation and other economic indicator is applied. Empirical Framework The foundation of this research is based on the relationship and impact of the monetary policy to the stock exchange performance. “The link between monetary policy and the stock market is of particular interest. Stock prices are among the most closely watched asset prices in the economy and are viewed as being highly sensitive to economic conditions. Stock prices have also been known to swing rather widely, leading to concerns about possible "bubbles" or other deviations of stock prices from fundamental values that may have adverse implications for the economy. It is of great interest, then, to understand more precisely how monetary policy and the stock market are related.” (Bernanke, 2003). In the same speech Bernanke further opined that “unanticipated changes in monetary policy affect stock prices not so much by influencing expected dividends or the risk-free real interest rate, but rather by affecting the perceived riskiness of stocks. A tightening of monetary policy, for example, leads investors to view stocks as riskier investments and thus to demand a higher return to hold stocks.” (Bernanke, 2003). Using the actual data gathered for the United States to test the theoretical framework of Taylor’s Principle the following result reveals the relationship of Monetary Policy and the Stock Market that supports the assertion of Bernanke. The following analysis made use of data gathered over twelve years covering the period the first quarter of two thousand (Q1:2000) up to the last quarter of two thousand eleven (Q4:2011). The data include the GDP, CPI and Equity or the stock market value and the interest rates covering the same period. The table above shows that even a 0.07% decrease in coefficient affects the inflation by 40% and the output gap by 20%. This shows the significant trend displayed in the mid 2000s. Using the Wald test to confirm the finding The table above will show the visual representation of the figures to determine how it performs in predicting the variability of the dependent variable. This however may have been the offshoot of the real estate crisis that prompted the Monetary Authority to implement remediation measures that is aimed at arresting the downward trend of the economy and stimulating the public to spend more. This is confirmed by the Chow Break point Test below: After significantly adjusting the numbers where the coefficient is at negarive 0.16% there is also a mark increase in the R-Squared are noted. Adjusting the model a bit to show the first estimate shows a considerable increase in R-squared which indicated the meaningful inclusion of significant regressors that validates the variability of the dependent variables. The normality test as shown above rejects the hypothesis of normality in the distribution of the residual. Reversing the trend to a point where the model will show significant changes in the values of Finally a coefficient of a positive 0.48% will show a 0.30% in inflation and 0.35% output gap. Data Description The data have been obtained from various sources primarily it is the stock exchange performance, the interest rates, the consumer price index, and the gross domestic product of the countries that is the focus of this study. Primarily it is the input of the formula indicated in the Taylor’s principle. China According to experts China’s Renminbi is heavily undervalued. Monetary policy makers in China have set the exchange rate of the Renminbi based on China’s needs and not on its actual value. China was selected for consideration in this study to show what should be the actual value of the Renminbi. The result of the regression model generated through eViews explains the relationship between Republic of China's GDP, the interest rate determined by the Central Bank and equity as the independent variables while equity stands as the dependent variable. The explanatory power of the model is 92.6%. The t-test, which determines whether or not the specific variable has a significant effect in the movement of the dependent variable, shows that GDP and Interest rate have significant effect while equity has no significant effect because it is below the 5% level of significance. United States Being a market economy, the United State’s Dollar is not only sensitive to market forces such as the performance of its stock exchange but also to market forces such as its reserve in gold or other internationally accepted negotiable instruments. The truism of the formula indicated earlier is better tested in the United States. Empirical Results Conclusion References Gali, J., 2008. Monetary Policy , Inflation, and the Business Cycle: An introduction to the new Keynesian Framework. 1st Edition ed. New York: Princeton University Press. Koenig, E. F., Leeson, R. & Kahn, G. A., 2012. The Taylor Rule and the Transformation of Monetary policy. New York: Hoover Inst Press. Mishkin, F. S., 2009. Monetary Policy Strategy. 1st Edition ed. Boston: MIT Press. Mun Wai, C. & Ying, S. H., 2008. Singapore and Asia in a Globalized World: Contemporary Economic Issues and Policies. 1st Edition. ed. Singapore: World Scientify Publishing Company. Shih, V. C., 2009. Factions and Finance in China: Elite Conflict and Inflation. Cambridge: Cambridge University Press. Read More