How Do Stock Prices Volatility Affect the Money Policy - Essay Example

How do stock prices volatility affect the money policy? One of the most effective tools of the central bank of a country has at its disposal is the Monetary policy (Maskay, 2007). The policy aims to achieve the various macroeconomic goals set by the government. The policy regulates interest rates and the money supply so as to maintain balance in an economy. Stock markets are the non-physical facilities in a country basically used for economic transactions. They directly determine the economic strengths of the country as well as its development. The changes in the stock prices have a significant impact on the macroeconomics. Therefore they have an effect on interest rates, inflation rates and money supply. These variables are controlled by monetary policy made by the central banks of countries or federal reserves and the policy determination is therefore depended on the stock prices. This paper discusses how the movements in stock prices affect determination of monetary policy. How do stock prices volatility affect the money policy? Monetary policy is the process by which the central bank or a federal reserve regulates the money supply and interest rates in order to achieve a major economic goal. On the other hand the stock market is considered as the country’s economic strength and development since it’s a non-physical facility of economic transactions. In any particular country, the economy strongly reacts to stock prices movement and in most cases economic recession is preceded by crash in stock markets. There is a very important relationship between the central banks of countries and stock markets. This makes the monetary authorities to make monetary decisions and policies by closely monitoring the stock market volatility. This ensures the authorities maintain a macroeconomic balance. According to Rigobon and sack 2001, volatility of stock prices significantly impact macroeconomics hence an important factor in determining the monetary policy. As mentioned earlier, this paper discusses the how stock price volatility affects monetary policy. This is addressed by using simple models of data from the international monetary fund in the quarterly series as at December 2010. The data used in the research is UK data ranging from 1990 first quarter to 2010 fourth quarter. The variables contained in this data set are the real UK GDP (RGDP), the consumer price index (CPI) and the interest rates set by the Bank of England The international monetary fund has 188 member countries. These countries work to foster global monetary cooperation, financial stability security, reduce poverty around the world, and promote sustainable economic growth and high employment. These being the organizations objectives it’s important to undertake the research. The fund works with developing countries in the bid to enable them reduce poverty to achieve macroeconomic stability. The research focuses on the UK. It is interesting to research on this topic so as to clearly understand how the bank makes monetary policies in relation to stock prices. Additionally understanding the various factors that underline the monetary policies and how these policies affect the global money markets. The research also enable identify any other factor that may be used to make monetary policies apart from basing on the stock prices. The expected results will not basically be on how the movement of stock prices affects monetary policy but it will include the general effect of these changes to interest rates and money supply. The results expected are aligned in two possible ways whereby the Bank of England should be mainly concerned with maintaining price stability. There should be no response to the stock volatility in case they don’t help target inflation. This is because the stock prices are too volatile. If this volatility is used in determining the monetary policy it may cause unpredictable effects on markets hence leading to macroeconomic instability. If an aggressive rule targeting inflation is set the output and inflation will stabilize even if the stock prices are volatile regardless of the source of the volatility. Contrary to this opinion it’s expected that the international monetary fund stipulates various monetary rules in place which do not destabilize the volatile stock prices. The monetary policy should be aimed at not only forecasting future inflation but also asset prices of the stocks. This is because these prices refer to future consumptions and should be set alongside consumer price index as target variables (Cecchetti et al 2000) Stock prices will reflect whether the economy of a country is doing well or not. The movements in stock prices have a significant impact on macroeconomics. Therefore the stock prices volatility is likely to be an important factor in the determination of monetary policy (Rigobon and Sack, 2001). This relationship between stock market volatility and monetary policy and is best analyzed by studying the effects of stock market volatility on both interest rates and money supply in the UK The relationship between the stock prices and monetary policy can be addressed by formulating hypotheses which are tested using the simple OLS methods. The Taylor rule is used which is a very simple but powerful tool on how to set monetary policy. The standard rule takes the form shown below Where ∝ - is the stabilizing interest of an economy. This occurs when πt = πt* yt = yt* πt - πt* is the inflation gap. is the output gap is the stochastic term that is; the value expected conditional to information available at the time From the above rule, the recommendation is that if inflation is above target level, the interest rate should rise above the stabilizing interest rate and if the inflation rate is below the target level the interest rates should decrease. It also recommends that if there is a positive output gap; that’s is the real GDP is more than the potential real GDP, then the interest rates should be set above the stabilizing interest rate and if the output gap is negative the rates should be set below the stabilizing interest rates.. According to Taylor (1993), equal weights should be placed on both the inflation rate and output gap and therefore. This is to prevent use of more aggressive policy to target inflation if more weight is placed on inflation gap. The objectives of this rule are to ensure there is price stability and the employment rates at the maximum. If Bank of England does not target other variables than ones specified by Taylor’s Rule then inflation rate and the output gap can be correctly specified. The various literature reviews on whether there should be inclusion of other variables into this regression model to allow for appropriate analysis of monetary policy show differences in arguments. Various scholars have opposite views on the inclusion of stock price movements into the model to be estimated, for instance; According to Bernanke and Gertler, (2000 and 2001); Vickery, (2000), stock prices should not key determinants for monetary policy. On the other hand Cecchetti et al., (2000); Cecchetti et al., (2002) believe that stock price movements do provide critical information for shaping monetary policy. For this opposite views there are various hypotheses that are formulated to help explain whether and how the central bank should respond to stock price volatility but within a more general monetary policy strategy. These hypotheses include; To understand how stock price volatility affect the interest rates in the monetary policy To understand how the stock price volatility affect the money supply as a component of monetary policy To understand the general relationship between stock prices volatility and monetary policy Using Taylor rule, the first two hypotheses are basing on indirect effect on the monetary effect by the stock prices volatility. The rule will stipulate the changes in the nominal interest rates by the Bank of England to respond to the divergence of actual inflation rates. It will also show how the changes occur in response to changes of actual GDP from the potential GDP. If both inflation rate and output gap are placed constant that is 0.5 as suggested by Taylor (1993), the following regression is used to track changes in the monetary policy. This will help understand how changes in stock prices affect interest rates Where; is the expected inflation is the expected output gap with as the stochastic term From the data the inflation rates are statistically significant hence has an effect on the interest rates. To determine how stock price volatility affects the money supply component of the monetary policy the following regression is formulated. Where S is the change in stock prices M2 is percentage change in money supply is an intercept G is the real GDP U is the percentage money supply change The above regression is an M2 component for money supply since it’s a broad classification of money used by economists to explain different monetary conditions and determine the amount of money in circulation. In the null hypothesis the inflation rate therefore stock prices volatility will not affect the change in money supply. When the inflation rates are not equal to zero there are significant changes in money supply. The real GDP and unemployment yearly percentage change are additional variables used as control variables. These two are important factors since industries react to changes in the economy therefore and the real GDP is an important factor in determining stock prices. For these hypotheses to be determined the Taylor Rule is reformulated into the Augmented Taylor Rule. This is in order to include the effect of stock price movement. The rules is as follows In the equation n is the number of lags of stock price volatility S that will be introduced to model the monetary effect. In the null hypothesis the estimated values if zero should be rejected since they will imply that stock prices should not key determinants for monetary policy. It’s expected that the stock price volatility impact on monetary policy may be indirect through its impact on interest rates and the money supply. From the literature above the analysis starts by simple Taylor rule: Where is the log of interest rate is the actual inflation rate, is the desired level of inflation, is the actual output and is the potential output. The variables needed to be used; that is; the log of interest rate, the year-on-year inflation percentage rate and the output gap are already calculated using the command quick or generate series and included in the data set. For convenience is set to zero and this means that the interest rate will only be depended on actual level of inflation and the output gap only. The graphical representation is obtained by plotting the variables of interest yields The representation shows that inflation and output gaps have similar behavior. The rates of interest remain stable for most of the period up to 2008 after which there is a large decrease. This maybe as a result of a financial crisis In addition to this the Taylor rule is estimated using the OLS estimator. In the case both the inflation rate and the output are positive. The results are tabulated below From the table, inflation coefficients and output are positive and therefore very significant. Any increase in inflation rate leads to a significant increase in the interest rate. The R2 indicate that the model in use can explain the about 25% of the variability of the dependent variables. Since the associated probability is smaller than 0.05, the F-statistic urges favorably of the model correctness. However the data may suffer from a problem of serial correlation since the DW statistics score is about 0.06. According to Taylor (1993), the inflation rate and output should be equal set at 0.5 by the monetary policy and therefore both equally serve in shaping the monetary policy. In most cases there is a severe inflation-targeting monetary policy whereby the inflation weight is far larger than the output gap. This restriction is tested using Wald Test. In this case the null hypothesis has the and set to constant according to Taylor. The results obtained from the Wald test are From this report the value from the Wald test is significant hence the value of inflation rate and output should not be equal. This implies that these two variables weigh differently in shaping the monetary policy. For a visual impression of the model a consideration is made on its performance in prediction of the variability of the dependent variable. From the results obtained the model underestimates the actual data at the beginning but overestimates it later on as from year 2008. The basic graph obtained is shown below The conclusion made from the graph is that the model maybe mis-specified and purposely may be affected by the absence of some variables. This issue may be addressed basing on the bubble at the beginning of 2001 in the era of dotcom. This is to determine if this bubble had an effect on the money policy decisions. For this case the null hypothesis is if there was no break and the hypothesis is the break occurred at the first quarter in the year 2001. The results obtained from the check break test show are represented below All the reported statics show that the bubble played a major role in shaping the monetary policy. This results in rejecting the null hypothesis. Basing on the literature the stock price volatility indirectly affects the shaping the monetary policy To estimate this phenomenon the augmented Taylor rule is used. Where Is the year-to year customer index price change for stock volatility A specific general approach is used in estimation of this by including lags in the value for s. the different lags are used to determine significance of each of the lags. The estimation from the first lag produces the following results Comparing the data with the one without the lag, the R2 values increase therefore the model can explain dependent variable variability. The coefficient associated to s shows some differences in the various values and therefore mild significance evidence. This evidence clearly shows that price volatility brings more information into the model and therefore accepts that the interest rates go up if the stock prices increase. The re-estimated results of the model with the second lag of s produce substantially different results. The value of s loses significance and moreover changes the sign. The second coefficient is closer to the region of rejection. This misspecification leads to the conclusion that the first lag is significant hence should be part of the model. However this can also be as a result of the model not satisfying the main assumptions which are used in classical regression models. This requires various tests to ascertain the problem. Form the various diagnostic tests the null hypothesis is rejected or there is insufficient evidence to reject it and therefore the conclusion is that this model is not satisfying the main assumptions of the classical regression models. The model specifically suffers from the serial correlation as well as condition known as heteroskedasticity. This model is re-estimated using Newey-West option. This re-estimation is done to obtain the robust standard errors and none of these variables enter the model to produce any significant results as the table below shows However this shows the expected signs of significance. This result may be determined by the fact that stock price volatility indirectly affects monetary policy. This therefore leads to carrying out a test using the Generalized Method of Moments (GMM) Estimation. The regression of estimation is shown below. From this regression if the values are zero this implies that the stock price volatility have an indirect effect to decisions of the monetary effect but if that’s not the case then it there is a direct effect of the stock prices volatility on the monetary policy is an e The regression results obtained show that inflation and output gap are affected by the stock prices volatility. From the IV procedure the following results are obtained The choice of the instrument is supported by the probability which is associated with J-statistic. The coefficient associated with s is statistically insignificant but may have some evidence of indirect relationship between stock price volatility and interest rates. This determines the monetary policy decisions. From these results it can be concluded that there is an indirect relationship in one direction between the stock prices volatility and market policy and therefore the stock prices volatility leads to the market policy though indirectly. From the analysis in this paper in which the effect of the stock prices on monetary policy was studied it is noted that the interest rates are directly affected by the stock price volatility. From both the regressions used to determine this relationship the changes in interest rates are small and positive. This clearly that holding all other variables constant the stock prices account for a small percentage in changes in the interest rates. This purposely shows that the stock prices will affect monetary policy but will not involve other variables such as inflation. Additionally the stock prices are affected by the money supply component of the money policy but this component does not cause the volatility. This component can only be used to control excessive stock price volatility. To prevent misalignments the monetary policy therefore is supposed to include stock prices in their decisions. The stock prices included in the monetary policy should strictly be on preventing economic bubbles and ensure macroeconomic stability. References Petersen, K. B. (2007). Does the Federal Reserve follow a non-linear Taylor rule?. University of Connecticut, Department of Economics Working Paper Series, n. 37. Rigobon, R. and Sack, B. (2002). The impact of monetary policy on asset price. NBER WP n. 8794. Vickers, J. (2000). Monetary policy and asset prices. The Manchester School, 68 (1): 1-22. Read More