“EFFECT OF MONETARY POLICY ON INDIAN STOCK MARKET”

A PROJECT STUDY SUBMITTED IN PARTIAL FULFILLMENT

FOR THE REQUIREMENT OF THE TWO YEAR

POST GRADUATE DIPLOMA IN MANAGEMENT (2012-14)

BY

ROHIT C. AKIWATKAR

Roll No.: 151

LAL BAHADUR SHASTRI INSTITUTE OF MANAGEMENT, DELHI

JANUARY, 2014
 ACKNOWLEDGEMENT

I would like to take this opportunity to express gratitude to my mentor, Dr. V. K. Mehta, for
providing me an opportunity to work on this project. His constant guidance and support made this work
an enriching experience for me. I was able to learn so much about the holistic, integrated, principle-
centric approach for solving problems.

I would also like to express my deep sense of gratitude towards the institute, Lal Bahadur
Shastri Institute of Management for providing me an opportunity and necessary recourses for the
successful completion of my project.

Lastly, I would really acknowledge my friends for their immense support and continuous
encouragement from time to time.

Rohit C. Akiwatkar
PGDM-General, 2012-14
LBSIM, New Delhi.

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 EXECUTIVE SUMMARY

The project titled “The Effect of Monetary Policy on Indian Stock Markets” examines the
influence of monetary policy variables (such as broad money), FII growth and intermediate target
(inflation rate) on stock market performance as measured by growth rate of stock market capitalization
for the period 2003 through 2013(Aug) for India. This was done through econometric method of
analysis using vector error correction model on the data and analyzing their impulse response functions,
graphs and forecast variance decomposition. The study was based on theories such as the quantity
theory of money, transmission mechanism of money, rational expectations theory, efficient market
hypothesis and theory of money neutrality and empirical evidence from developed countries and
developing countries. The study has been able to establish that the supply of money, the condition of
credit and the price level influence the performance of the stock market over the short, medium and
long run period. The unit root test performed on the data showed presence of non-stationarity in the
variables at levels but were stationary in their first difference. Cointegration test showed the presence of
long run equilibrium relationship among the variables. All countries had the same lag length of 24
because that was the lag at which the information criteria were at their minimum values. Analysis of the
impulse response functions and decomposition of variance for Market growth has been done to show
the effect of monetary policy variables and FII growth. The analysis shows that monetary policy
variable i.e. broad money affects the stock market growth moderately in the short and strongly in the
long run and FII growth affects the same strongly in the short run and weakly in the long run.

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 LIST OF TABLES

NAME OF TABLE PAGE NO.

4.1 ADF Test for level of variable 25

4.2 ADF Test for first difference of variable 26

4.3 Cross-equation covariance matrix 29

4.4 Response on Market growth due to one standard shock in variables 29

LIST OF FIGURES

NAME OF FIGURE PAGE NO.

4.1: Response on Market growth due to one standard shock in money growth 30
4.2: Response on Market growth due to one standard shock in FII growth 30
4.3: Response on Market growth due to one standard shock in inflation rate 31
4.4: Decomposition of variance for Market Capitalization (growth) 32

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 CONTENTS

Certificate i
Acknowledgements ii
Executive Summary iii
List of Tables and Figures iv
Contents v

Chapter 1. Introduction 1-5

1.1 Introduction
1.2 Monetary Policy of India
1.2.1 Monetary Operations
1.3 Indian Stock Market

Chapter 2. Literature Review 6-20

2.1 Introduction
2.2 Literature Review
2.3 Theories of monetary policy and stock markets
2.4 Empirical Evidence

Chapter 3. Research Methodology 21-24

3.1 Introduction
3.2 Objectives
3.3 Hypothesis Formulation
3.4 Model

Chapter 4. Data Analysis and Interpretation 25- 32

4.1 Time Series Properties of Data
4.2 Regression Result
4.2.1 VECM analysis
4.2.2 Impulse responses function of Market Growth
4.2.3 Decomposition of variance for Market Growth

Chapter 5 Conclusion and Policy Recommendations 33-36

5.1 Conclusion
5.2 Policy recommendations

Bibliography 37
Appendix1 Decomposition of variance for Market Capitalization (growth) 38
Appendix2 Records of Meetings with the Project Guide 41

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 CHAPTER 1
INTRODUCTION
1.1 Introduction
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. The monetary policy
goals of the Reserve Bank of India (the Central Bank of the India), are often stated as “price
stability” and “sustainable economic growth”. Recently 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.

1.2 Monetary Policy of India

Monetary policy is the process by which monetary authority of a country, generally a
central bank controls the supply of money in the economy by exercising its control over
interest rates in order to maintain price stability and achieve high economic growth. In India,
the central monetary authority is the Reserve Bank of India (RBI) is so designed as to
maintain the price stability in the economy.

1.2.1 Monetary operations:

Monetary operations involve monetary techniques which operate on monetary magnitudes
such as money supply, interest rates and availability of credit aimed to

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maintain Price Stability, Stable exchange rate, Healthy Balance of Payment, Financial
stability, Economic growth. RBI, the apex institute of India which monitors and regulates
the monetary policy of the country stabilizes the price by controlling Inflation. RBI takes into
account the following monetary policies:
1. Open Market Operations
An open market operation is an instrument of monetary policy which involves buying
or selling of government securities from or to the public and banks. This mechanism
influences the reserve position of the banks, yield on government securities and cost of bank
credit. The RBI sells government securities to contract the flow of credit and buys
government securities to increase credit flow. Open market operation makes bank rate policy
effective and maintains stability in government securities market.

2. Cash Reserve Ratio

Cash Reserve Ratio is a certain percentage of bank deposits which banks are required
to keep with RBI in the form of reserves or balances .Higher the CRR with the RBI lower
will be the liquidity in the system and vice-versa.RBI is empowered to vary CRR between 15
percent and 3 percent. But as per the suggestion by the Narshimam committee report the CRR
was reduced from 15% in the 1990 to 5 percent in 2002. As of October 2013, the CRR is 4.00
percent.

3. Statutory Liquidity Ratio

Every financial institution has to maintain a certain quantity of liquid assets with
themselves at any point of time of their total time and demand liabilities. These assets can be
cash, precious metals, approved securities like bonds etc. The ratio of the liquid assets to time
and demand liabilities is termed as the statutory liquidity ratio. There was a reduction of SLR
from 38.5% to 25% because of the suggestion by Narshimam Committee. The current SLR is
23%.

4. Bank Rate Policy

The bank rate, also known as the discount rate, is the rate of interest charged by the
RBI for providing funds or loans to the banking system. This banking system involves
commercial and co-operative banks, Industrial Development Bank of India, IFC, EXIM
Bank, and other approved financial institutes. Funds are provided either through lending
directly or rediscounting or buying money market instruments like commercial bills and
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treasury bills. Increase in Bank Rate increases the cost of borrowing by commercial banks
which results into the reduction in credit volume to the banks and hence declines the supply
of money. Increase in the bank rate is the symbol of tightening of RBI monetary policy. As of
1 January 2013, the bank rate was 8.75% and as on 29 October, 2013 bank rate is 8.75%

5. Credit Ceiling
In this operation RBI issues prior information or direction that loans to the
commercial banks will be given up to a certain limit. In this case commercial bank will be
tight in advancing loans to the public. They will allocate loans to limited sectors. Few
example of ceiling are agriculture sector advances, priority sector lending.

6. Credit Authorization Scheme

Credit Authorization Scheme was introduced in November, 1965 when P C
Bhattacharya was the chairman of RBI. Under this instrument of credit regulation RBI as per
the guideline authorizes the banks to advance loans to desired sectors.

7. Moral Suasion
Moral Suasion is just as a request by the RBI to the commercial banks to take so and
so action and measures in so and so trend of the economy. RBI may request commercial
banks not to give loans for unproductive purpose which does not add to economic growth but
increases inflation.

8. Repo Rate and Reverse Repo Rate

Repo rate is the rate at which RBI lends to commercial banks generally against
government securities. Reduction in Repo rate helps the commercial banks to get money at a
cheaper rate and increase in Repo rate discourages the commercial banks to get money as the
rate increases and becomes expensive. Reverse Repo rate is the rate at which RBI borrows
money from the commercial banks. The increase in the Repo rate will increase the cost of
borrowing and lending of the banks which will discourage the public to borrow money and
will encourage them to deposit. As the rates are high the availability of credit and demand
decreases resulting to decrease in inflation. This increase in Repo Rate and Reverse Repo
Rate is a symbol of tightening of the policy. As of October 2013, the repo rate is 7.75 % and
reverse repo rate is 6.75%

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1.3 Indian Stock Market
A stock market or equity market is the aggregation of buyers and sellers (a loose
network of economic transactions, not a physical facility or discrete entity) of stocks (shares);
these are securities listed on a stock exchange as well as those only traded privately. Most of
the trading in the Indian stock market takes place on its two stock exchanges: the Bombay
Stock Exchange (BSE) and the National Stock Exchange (NSE). The BSE has been in
existence since 1875. The NSE, on the other hand, was founded in 1992 and started trading in
1994. However, both exchanges follow the same trading mechanism, trading hours,
settlement process, etc. At the last count, the BSE had about 4,700 listed firms, whereas the
rival NSE had about 1,600. Out of all the listed firms on the BSE, only about 500 firms
constitute more than 90% of its market capitalization; the rest of the crowd consists of
highly illiquid shares.

Almost all the significant firms of India are listed on both the exchanges. NSE enjoys
a dominant share in spot trading, with about 70% of the market share, as of 2009, and almost
a complete monopoly in derivatives trading, with about a 98% share in this market, also as of
2009. Both exchanges compete for the order flow that leads to reduced costs, market
efficiency and innovation. The presence of arbitrageurs keeps the prices on the two stock
exchanges within a very tight range.
The National Stock Exchange (NSE) is stock exchange located in Mumbai, India.
National Stock Exchange (NSE) was established in the mid 1990s as a demutualised
electronic exchange. NSE provides a modern, fully automated screen-based trading system,
with over two lakh trading terminals, through which investors in every nook and corner
of India can trade. NSE has played a critical role in reforming the Indian securities market
and in bringing unparalleled transparency, efficiency and market integrity.
NSE has a market capitalisation of more than US$989 billion and 1,635 companies
listed as on July 2013. Though a number of other exchanges exist, NSE and the Bombay
Stock Exchange are the two most significant stock exchanges in India and between them are
responsible for the vast majority of share transactions. NSE's flagship index, the CNX NIFTY
50, is used extensively by investors in India and around the world to take exposure to the
Indian equities market.
NSE was started by a clutch of leading Indian financial institutions. It offers trading,
clearing and settlement services in equity, debt and equity derivatives. It is India's largest
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exchange, globally in cash market trades, in currency trading and index options. NSE has
diversified shareholding. There are many domestic and global institutions and companies that
hold stake in the exchange. Some of the domestic investors include LIC, GIC, State Bank of
India and IDFC Ltd. Foreign investors include MS Strategic (Mauritius) Limited, Citigroup
Strategic Holdings Mauritius Limited, Tiger Global Five Holdings and Norwest Venture
Partners X FII-Mauritius, who have a stake in NSE. As on June 2013, NSE has 1673 VSAT
terminals and 2720 leaselines, spread over more than 2000 cities across India.

In this study, both descriptive and econometric methods of data analysis would be
adopted. The descriptive method of analysis would be in the form of tables. The econometric
technique of analysis makes use of Vector Error Correction Model (VECM). This method is
used to examine the long run effect of monetary policy on stock market performance. In this
way, a true, empirically valid relationship between monetary policy and stock market
performance would be established. This research project consists of five (5) chapters in all.
Chapter One gives a detailed introduction and background to the study. This chapter consists
of background of the study, overview of India’s monetary policy and stock market. Chapter
Two gives a detailed analysis of all the literature reviewed, and the various postulations and
positions as well as alternative theories concerning this topic. The themes method of literature
review is adopted in which the views that share the same idea are reviewed together and those
with opposing views are subsequently analysed. The theoretical perspective as well as
empirical evidence for the study are also done in this chapter. Chapter Three contains
statement of the research problem, justification of the study, objectives of the study (general
and specific objectives), scope of the study, hypotheses postulated and research methodology.
It explores the research methodology in detail, explains the techniques of data analysis
adopted and specifies the model which the research is based on. Chapter Four is where the
data is analysed using vector error correction model (VECM). Here, various statistics are
used to test the hypotheses, to determine the effects of monetary policy on stock market
performance. Chapter Five concludes the study with policy recommendations and conclusion

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 CHAPTER 2
LITERATURE REVIEW

2.1 Introduction
Having gotten a clearer picture of both monetary policy and stock markets, we shall
then proceed to examine the various theories and positions that have been propounded in the
literature to examine how and to what extent monetary policy affects stock market
performance. Some economists such as Ioannidis and Kontonikas (2006) and Jensen et al
(1996) believe that changes in monetary policy affects stock market performance and they
especially lead to changes in stock prices. Whereas, others such as Bordo and Jeanne (2000)
and Fair (2001) are of the opinion that monetary policy has little or no effect on stock market
performance. Among those who believe monetary policy affects stock market performance,
there are divergences as to which tool of monetary policy is more important. While some like
Rigobon and Sack (2001), Hayford and Maliaris (2002) believe that interest rates are more
important, others like Wing et al (2005) and Mehar (2000) believe that changes in the supply
of money is the dominant factor in monetary policy transmission mechanism. Finally, authors
are divided as to whether expansionary or contractionary, inflationary or dis-inflationary
monetary policy has negative, positive or non-statistically significant relationship with stock
market performance. This chapter is divided into five sections. The first section is the
introduction. The second section gives a literature review. The third section which is the
theoretical perspective section shall examine the theories which have been propounded on
stock markets and on monetary policy. The fourth section which is the empirical evidence
section presents a cross section of empirical and econometric testing performed on country
data showing how monetary policy affects stock markets. The fifth section concludes the
chapter.

2.2 Literature Review

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

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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 macro economy 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. A number of
macroeconomic and financial variables that influence stock markets have been documented
in the empirical literature without a consensus on their appropriateness as regressors. These
works include Lanne (2002), Campbell and Yogo (2003), Jansen and Moreira (2004),
Donaldson and Maddaloni (2002), Goyal (2004), and Ang and Maddaloni (2005). Frequently
cited macroeconomic variables are GDP, price level, industrial production rate, interest rate,
exchange rate, current account balance, unemployment rate, fiscal balance, etc. De Long and
Olney (2009) asserted that ever since stock markets came into existence in the world,
economists have been saddled with the arduous task of making these financial intermediaries
work efficiently and effectively. This is because stock prices are among the most closely
watched asset prices in the economy and are viewed as being highly sensitive to economic
conditions The level of the stock market is a key variable which indicates the pulse of
economic activity in a country and together with other variables such as the real Gross
Domestic Product, the unemployment rate, the inflation rate, the interest rate and the
exchange rate give a summary of the macroeconomics of that country. Stock prices have also
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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. Durban (2000) claimed that many financial crises in the past have been traced
to a crash in the stock markets and one of the consequences of financial crises are decline in
the level of the stock markets. In fact, stock markets are so important in any economy that the
level of the stock markets is the key economic indicator which is heard about most often.
Stock market indicators such as market capitalization, all-shares index, value and volume of
stocks traded in the stock exchange are announced on the news daily. This shows the great
importance of the stock markets to any economy in the world. Many African countries are
still classified as underdeveloped in economic journals and publications of the IMF and the
World Bank because their stock markets are still in their infancy stage. Common stock
markets in the world include S&P 500 in the United States, the FTSE 100 in the United
Kingdom, the Nikkei Stock Average in Japan, the Hang Seng in Hong Kong, DAX in
Germany, CAC 40 in France, Bovespa in Brazil to mention a few. In Nigeria, we have our
own Nigeria Stock Exchange, formerly Lagos Stock Exchange. Eapen (2002) opined that
stock market is the best indicator to forecast future economic activities and describe the
actual causal effect between future economic growth and stock prices. An efficient stock
market provides guidelines as a means to keep appropriate monetary policy through the
issuance and repurchase of government securities in liquid market which is an important step
towards financial liberalization. Similarly, a well organized and active stock market could
modify patterns of demand for money and would help create liquidity that eventually
enhances economic growth. (Caporale et al, 2004).

The nature of the relationship between asset prices movements and monetary policy is
currently a hotly debated topic in macroeconomics (Bernanke, 2002). It is of great interest,
then, to understand more precisely how monetary policy and the stock markets are related.
Monetary policy actions have their most direct and immediate effects on the broader financial
markets, including the stock market, government and corporate bond markets, mortgage
markets, markets for consumer credit, foreign exchange markets, and many others. Bernanke
(2002) postulated that if all goes as planned, the changes in financial asset prices and returns
induced by the actions of monetary policymakers lead to the changes in economic behaviour
that the policy was trying to achieve. Thus, understanding how monetary policy affects the
broader economy necessarily entails understanding both how policy actions affect key
financial markets, as well as how changes in asset prices and returns in these markets in turn
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affect the behaviour of households, firms, and other decision makers. Studying these links is
an ongoing enterprise of monetary economists both within and outside the Federal Reserve
System. As Bernanke and Kuttner (2005) point out, some observers view the stock market as
an independent source of macroeconomic volatility to which policymakers may wish to
respond. Monetary policy shifts significantly affect stock returns, thereby supporting the
notion of monetary policy transmission via the stock market.

Broader financial markets though, for example the stock market, government and
corporate bond markets, mortgage markets, foreign exchange markets, are quick to
incorporate new information. Therefore, a more direct and immediate effect of changes in the
monetary policy instruments may be identified using financial data. As Blinder (1998) notes,
“Monetary policy has important macroeconomic effects only to the extent that it moves
financial market prices that really matter—like long-term interest rates, stock market values,
and exchange rates.” Economists such as Cassola and Morana (2004) have observed that
monetary policy decisions generally exert an immediate and significant influence on stock
index returns and volatilities in both European and US markets. Their findings also indicate
that European Central Bank’s (ECB) press conferences following monetary policy decisions
on the same day have defined impacts on European index return volatilities, implying that
they convey important information to market participants. Many more assertions and ideas as
to the relationship between monetary policy and stock markets abound in the literature and
they shall be appropriately examined during the course of this work. However, there is no
consensus opinion as to this topic as economists worldwide are still in debates about the
issue. Therefore, this work wishes to address the issue of whether monetary policy affects
stock market performance and how monetary policy shocks are transmitted to the stock
market.

The relationship between monetary policy and stock markets can be viewed in two
folds: the effects of monetary policy on stock markets and the effects of stock markets on
monetary policy. Economist’s views and opinions on this issue are divergent. Considering the
issue of the effects of stock markets on monetary policy, the response of asset prices to
central bank policy is a key component for analysing the impact of monetary policy on the
economy and because of their potential impact on the macro economy; stock market
movements are likely to be an important determinant of monetary policy decisions. The
American stock market crash of October 19, 1987 has made economists examine empirically
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if monetary policy has been influenced by high valuations of the stock market. Greenspan
(2002) stated that central banks should remain focused on achieving price stability and
maximum sustainable growth, suggesting that policymakers should respond to stock prices
according to their influence on the outlook for output and inflation. On the other hand, in
examining the impacts of monetary policy on stock markets, establishing quantitatively the
existence of a stock market response to monetary policy changes will not only be germane to
the study of stock market determinants; but will also contribute to a deeper understanding of
the conduct of monetary policy, and of the potential economic impact of policy actions or
inactions.
While economists agree that monetary policy should take stock prices into account as large
swings in stock prices, either related or unrelated to fundamentals, may have a destabilizing
impact on the economy; they nonetheless disagree on the ways they should do it. Identifying
the link between monetary policy and financial asset prices is highly important to gain a
better insight in the transmission mechanism of monetary policy, since changes in asset prices
play a key role in several channels. Therefore, it would be important to determine how
contractionary or expansionary; accommodative, neutral or tight monetary policy affects the
performance of the stock markets of various countries and whether there are any well defined
systems for implementing monetary policy that would lead to better stock market
performance all around the world. This project seeks to answer the questions “What are the
effects of monetary policy on stock market performance?”; “How do shocks in the growth
rate of market capitalization, money supply growth, lending rate and inflation rate affect the
performance of stock markets in both developing and developed countries? The linkage
between monetary policy decisions and stock markets’ performance is an important topic for
several reasons. There is a wide consensus among investors and researchers (Bernanke and
Kuttner, 2005); (Ioannidis and Kontonikos, 2006) that having reliable estimates of the
reaction of asset prices to the policy instrument is important since it makes it easier for
economists and central bankers to understand the function, and to assess the effectiveness of
stock market channels for monetary policy transmission. Availability of such estimates helps
to formulate effective policy decisions. This study is necessary and justified for the following
reasons. Previous researches done in the past on the transmission mechanism of monetary
policy on stock markets have majorly focussed on the effects of changes in the interest rates
on stock prices within a short period after the announcement of a change has been made and
how interest rates affect the average prices of stocks and shares. This is evident in Bernanke
and Kuttner (2005) and Hussain (2010). In addition, there has been little focus by researchers
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on effects of changes in growth rate of money supply on stock markets and such works as
Brunner, Friedman and Schwartz, Tobin (1978) are not recent. Furthermore, the previous
works have focussed on average stock prices of companies quoted in the respective country’s
stock exchange. This project would therefore improve on existing knowledge by empirically
analyzing the effects of growth rate of money supply, changes in interest rates and inflation
rate on stock market performance which would be proxied by market capitalization which
measures both the prices and volumes of all the stocks traded in the stock exchange of a
particular country. Furthermore, most research conducted in the past focus only on a
particular region and such results are highly misleading. For example, research on Federal
Reserve Bank’s monetary policy and its effect on the performance of the Dow Jones index
and the S&P 500; and effects of the European Central Bank’s (ECB) policy and its effect on
the stock markets of European countries are used to give policy advice to developing
countries and stock markets. This project makes use of panel data for 10 countries which cuts
across developed and developing countries in order to determine if there are differences in the
transmission mechanism of monetary policy on stock markets in different countries or if the
transmission mechanism is the same across all countries. The data from 1988 to 2008
provides recent information which can be used for determination of empirical evidence of
their relationship. Many studies performed on stock market data in the literature reviewed
made use of the vector autoregression (VAR) technique. However, they performed analysis
on stock market prices and indices but not on stock market capitalization. This study uses
vector error correction model (VECM) instead of VAR on market capitalization data to
determine if the conclusions would be similar or different. The reason for using VECM in
this analysis is that it helps to determine the long run equilibrium relationship between
variables especially if these variables are non-stationary at levels. (Lutkepohl,1999). Gujarati
(2004) claimed that the forecasts obtained by this method are in many cases better than those
obtained from the more complex simultaneous-equation models and that VECM can be used
to test multivariable causality. The significance of this study is to correctly determine how
changes in growth rate of money supply, changes in interest rates and inflation rate affect
stock market performance and be able to offer advice to policy makers on how to improve the
performance of stock markets taking note of the similarities and differences in the level of
economic development and stock market activity.

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2.3 Theories of monetary policy and stock markets
This research project was based on the following theories of monetary policy and
stock markets.
(a) The Efficient Markets Hypothesis
The Efficient Market Hypothesis (EMH) has been consented as one of the
cornerstones of modern financial economics. Fama (1970) first defined the term "efficient
market" in financial literature in 1965 as one in which security prices fully reflect all
available information. The market is efficient if the reaction of market prices to new
information should be instantaneous and unbiased. Efficient market hypothesis is the idea
that information is quickly and efficiently incorporated into asset prices at any point in time,
so that old information cannot be used to foretell future price movements. Consequently,
three versions of EMH are being distinguished depending on the level of available
information. The weak form EMH stipulates that current asset prices already reflect past price
and volume information. The information contained in the past sequence of prices of a
security is fully reflected in the current market price of that security. It is named weak form
because the security prices are the most publicly and easily accessible pieces of information.
It implies that no one should be able to outperform the market using something that
"everybody else knows".
The semi strong form EMH states that all publicly available information is similarly
already incorporated into asset prices. In other words, all publicly available information is
fully reflected in a security's current market price. The public information stated not only past
prices but also data reported in a company's financial statements, company's announcement,
economic factors and others. It also implies that no one should be able to outperform the
market using something that "everybody else knows".
The strong form EMH stipulates that private information or insider information too, is
quickly incorporated by market prices and therefore cannot be used to reap abnormal trading
profits. Thus, all information, whether public or private, is fully reflected in a security's
current market price. That means even the company's management (insiders) are not able to
make gains from inside information they hold. They are not able to take the advantages to
profit from information such as take over decision which has been made ten minutes ago. The
rationale behind this is that the market anticipates, in an unbiased manner, future
development and therefore information has been incorporated and evaluated into market price
in a much more objective and informative way than insiders.

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(b) Rational Expectations Theory
The theory of rational expectations was formulated by Lucas in the early 1970s. The
theory uses statistical methods to show that workers and businesses shape the economy by
interpreting and updating information about the economy’s future. As a result, government
monetary policies can be anticipated, and this expectation may alter the predicted outcome of
those policies. Lucas used the rational expectations theory to challenge many orthodox
economic assumptions of the 1970s, particularly the theories of British economist John
Maynard Keynes and the effectiveness of government intervention in the economy. In a
typical rational expectations model, the public adjusts its behaviour to announced monetary
policy. The theory suggests that the current expectations in the economy are equivalent to
what the future state of the economy will be.
This contrasts the idea that government policy influences the decisions of people in
the economy. There are two main parts to rational expectations. First, Lucas began with the
old assumption that recessions are self-correcting. Once people start hoarding money, it may
take several quarters before everyone notices that a recession is occurring. That is because
people recognize their own hardships first, but it may take awhile to realize that the same
thing is happening to everyone else. Once they do recognize a general recession, however,
their confusion clears, and the market quickly takes steps to recover. Producers will cut their
prices to attract business, and workers will cut their wage demands to attract work. As prices
deflate, the purchasing power of money is strengthened, which has the same effect as
increasing the money supply. Therefore, government should do nothing but wait the
correction out.
Second, government intervention can only range from ineffectualness to harm.
Therefore, any government attempt to expand the money supply cannot happen before a
businessman's decision to cut prices anyway. Keynesians are therefore robbed of the
argument that perhaps the central bank might be useful in hastening a recovery, since Lucas
showed that the central bank is not much faster than the market in discovering the problem.

(c) Quantity Theory of Money

This theory was described comprehensively by Irving Fisher (1911). It is the classical
view of how money is used in the economy, and what variables it affects. The quantity theory
of money is a theory of how the nominal value of aggregate income is determined. Because it
also tells how much money is held for a given amount of aggregate income, it is also a theory
of the demand for money. The most important feature of this theory is that it suggests that
13 | P a g e
interest rates have no effect on the demand for money. Fisher wanted to examine the link
between the total quantity of money M (the money supply) and the total amount of spending
on final goods and services produced in the economy PY, where P is the price level and Y is
aggregate output (income). (Total spending PY is also thought of as aggregate nominal
income for the economy or as nominal GDP.) The concept that provides the link between M
and PY is called the velocity of money, the rate of turnover of money; that is, the average
number of times per year that a unit of money is spent in buying the total amount of goods
and services produced in the economy. Velocity V is defined more precisely as total spending
PY divided by the quantity of money M.
The equation of exchange, which relates nominal income to the quantity of money
and velocity is given as: MV = PY. The equation of exchange thus states that the quantity of
money multiplied by the number of times that this money is spent in a given year must be
equal to nominal income (the total nominal amount spent on goods and services in that year).
Like other neoclassical economists, Fisher held the view that in the short run, monetary
influence was dictated by interest rates that were sticky initially though rising subsequently
while in the long run, the channel of influence was real cash balance. He argued that when
wealth increases as a result of a rise in the stock of money, people try to reduce their cash
balances by purchasing goods and services. Using the exchange equation of MV= PY, where
velocity (V) and output (Y) are held constant, doubling money stock (M) would lead to the
doubling of the price level (P). This means that when money stock increases following an
increase in gold stock and rise in reserve, for example, in the short run, commodity prices
will increase since it is assumed that output and velocity were fixed initially. This implies
that, the rate of inflation in the economy is entirely due to changes in the money supply.

(d) The Theory of Monetary Neutrality

A basic proposition in monetary theory, called monetary neutrality, states that in the
long run, a one-time percentage rise in the money supply is matched by the same one-time
percentage rise in the price level, leaving unchanged the real money supply and all other
economic variables such as interest rates. Money is said to be neutral if exogenous changes in
the supply of money have no effect on real quantities and real prices. Monetary neutrality
tells us that in the long run, the rise in the money supply would not lead to a change in the
domestic interest rate. The fact that the increase in the money supply has left output and
interest rates unchanged in the long run are referred to as long-run monetary neutrality. The
only result of the increase in the money supply is a higher price level, which has increased
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proportionally to the increase in the money supply so that real money balances M/P are
unchanged. If the Fisherian quantity theory is correct, then any change in M would lead to a
corresponding change in P, while the real variables, Y and V, remain unchanged. This is
known as the neutrality of money, a condition whereby changes to the money supply affect
only nominal variables.

2.4 Empirical Evidence

According to Bernanke (2003), understanding how monetary policy affects economic
activity remains one of the greatest challenges of academic and financial sector economists.
An important financial market that has been overlooked as a channel for a monetary
transmission mechanism is the stock market. While most economists agree that stock returns
are related to real economic activity, few have argued that stock returns play any role beyond
serving as a measure of expected future corporate profits. However, many economists are of
the opinion that stock market forms an important transmission path for monetary policy.
Previous empirical evidence broadly supports the notion that restrictive (expansive) monetary
policy decreases (increases) contemporaneous stock returns, as well as expected stock
returns. They further state that both the short and long run generally suggest that monetary
policy easing (tightening) produces higher (lower) stock market prices. Andersen, Bollerslev,
Diebold and Vega (2007) find no evidence of state dependence in the stock market’s response
to monetary news. There are two channels through which stock prices respond to monetary
news. The first and more traditional channel is the interest rate channel that relates to
economic activity primarily through consumption and investment. This channel of monetary
transmission relies on the effect of interest rate changes on loan demand. A cut in the interest
rates reduces the cost of borrowing for investment and leads to an increase in economic
activity. Furthermore, reduced cost of borrowing translates into lower cost of capital for
firms, increasing the present value of future cash flows and thereby directly affecting the
stock prices.
Alternatively, an increase in the cost of borrowing increases the cost of capital for
firms and reduces consumer demand. Hypothetically, the interest rate channel may lead to
time variation in the response of stock returns if the elasticity of investment borrowing varies
over time or if the inter-temporal elasticity of substitution of consumption is cyclical. But,
there is no clear economic reason for the effects of the interest rate channel to vary over the
business cycle and no prediction regarding the direction of possible variation. The second
channel of monetary policy transmission, the credit channel, can be subdivided into two
15 | P a g e
mechanisms: the bank loan channel and the balance sheet channel. The bank loan channel
stresses cyclicality in the availability of loans. A reduction in the supply of bank credit affects
the economic activity of bank-dependent borrowers. The balance sheet channel focuses on
changes in creditworthiness of firms due to procyclical fluctuations in the quality of their
balance sheets. The credit channel of monetary transmission predicts that firms should react
more to macroeconomic shocks in bad economic times for two reasons: First, due to a general
reduction in the availability of credit as the bank lending channel predicts. Second, due to a
further adverse effect on the balance sheets of the financially constrained firms. The
disaggregated data on firm-specific credit characteristics and stock returns can be combined
with the data on aggregate macro cycles to examine state dependence in the response of stock
returns in the cross section of firms. Banerjee and Adhikary (2000) posited that the rationales
for the relationship between the interest rate and stock market return are that stock prices and
interest rates are negatively correlated. Higher interest rate ensuing from contractionary
monetary policy usually negatively affects stock market return. This is because higher
interest rate reduces the value of equity as stipulated by the dividend discount model, makes
fixed income securities more attractive as an alternative to holding stocks, may reduce the
propensity of investors to borrow and invest in stocks, and raises the cost of doing business
and hence affects profit margin. On the contrary, lower interest rates resulting from
expansionary monetary policy boosts stock market. Smirlock and Yawitz (1985) state that
interest rate changes can impact equity prices through two conduits: by affecting the rate at
which the firm’s expected future cash flows will be capitalized, and by altering expectations
about future cash flows. In particular, they argue that an increase in interest rates causes stock
prices to decline and a decline in interest rates causes stock prices to rise.
Kraft and Kraft (1977) used time series analysis and found no causal relationship
from money supply to stock prices. Pearce and Roley (1985) examined the effects of money
supply news on stock prices, finding a negative relationship between unanticipated increases
in the money supply and stock prices. The hypothesized causal relation from money supply to
stock prices is often derived in two steps: an assumed negative causal relation from money
supply to interest rates, followed by an assumed negative causal relation from interest rates to
stock prices. Accordingly, the absence of a causal relation from money supply to stock prices
may be partly due to uncertainty over whether interest rates will fall (rise) as a result of an
increase (decrease) in the money supply. There is no evidence of cointegration or common
stochastic trends among money supply, interest rate, and stock prices. This contradicts the
view that money supply and stock prices hold a stable long-run relationship. The
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cointegration results further confirm that money supply does not have any long-run
explanatory power in predicting movements in stock prices. The research of Brunner,
Friedman and Schwartz, Tobin (1978) and others have established that a relationship exists
between changes in the money supply and changes in the prices of other assets held in an
investor’s portfolio. It is generally agreed that an unexpected increase or decrease in the
growth rate of money results in a change in the equilibrium position of money with respect to
other assets in the portfolio of investors. As a result individual investors try to adjust the
proportion of their asset portfolios represented by money balances. Since it also can be
expected that the time response of investors will be delayed, it has been hypothesized that
changes in the money supply cause changes in stock prices. If the hypothesis is true, then
changes in stock prices should respond to monetary disturbances with a lag. If such a lagged
relationship were to exist, that information could be used to formulate trading rules to allow
greater returns than from a buy and hold strategy.
Non-econometric tests of this model have been performed by Sprinkel and Palmer.
The thrust of these studies concluded that changes in stock prices resulted from changes in
monetary variables. These studies were followed by econometric studies by Homa and Jaffe,
Keran, Reilly and Lewis, Hamburger and Kochin, Malkiel and Quandt, and Meigs (1970).
The results of these studies purport to confirm that not only is there a strong linkage between
money supply and stock prices but also those monetary changes lead stock prices. The
conclusion which must follow from such results, however, is that if one can forecast changes
in money supply, one can determine at least in part future prices and returns of stocks. A
positive causal relation from money supply to stock prices is frequently hypothesized by
some financial media and financial analysts. The basis of this assertion is an assumed
negative causal relation from money supply to interest rates, and a negative causal relation
from interest rates to stock prices. Rigobon and Sack (2001) stated that the stock market
endogenously responds to monetary policy decisions at the same time that policy is reacting
to the stock market. Holding everything else equal, higher interest rates are associated with
lower stock market prices, given the higher discount rate for the expected stream of
dividends. Some proposed that soaring prices in the stock market have been fuelled by
moderate long-term interest rates and expectations of investors that profit margins and
earnings growth will hold steady, or even increase further, in a relatively stable, low-inflation
environment.
Sprinkel (1964) compared the turning points in a stock price index with the turning
points in the growth rate of money. He concluded that a bear stock market was predicted 15
17 | P a g e
months after each peak in monetary growth, and that a bull market was predicted two months
after each monetary trough was reached. Hamburger and Kochin (1972) started with the
standard valuation model and added current price level and the corporate bond rate to capture
the direct and indirect impacts of money supply on the stock market. They concluded that
changes in monetary growth could have a number of different effects on the stock market.
Pesando (1974) concluded that the inability of previous models to generate accurate forecasts
of stock prices was evidence against a structural and stable relationship between money
supply and common stock prices.
Mehar (2000) suggested that the central bank of a country can also play an important
role in the determination of stock prices (or market capitalization) through change in the
money supply. A higher liquidity in the market creates higher demand for shares in the
market, thus, increasing market capitalization. There is substantial empirical evidence that
found an influence of money supply on stock returns. For instance, Fama (1981) and Jensen,
Mercer and Johnson (1996) argue that increased nominal money supply leads to a portfolio
rebalancing toward other real assets. This upward reallocation results in upward pressure on
stock prices. Therefore, stock returns respond to unanticipated changes in nominal money
supply. On the other hand, purely nominal increases in money supply may lead to great
inflation uncertainty, and could have an adverse consequence on the stock market. Hence,
money growth could be regarded as a leading indicator of future inflation, which in turn
affects stock returns. Furthermore, increase in money supply leads to a falling in real interest
rates. Moreover, firms are faced with lower discount rates against future cash flows, and also
respond to increasing income by adjusting their investments so as to generate greater sales
and profits resulting in higher future cash flows and higher stock prices. Thorbecke (1997)
and Patelis (1997) found a positive correlation between expansionary monetary policy and
real stock returns, where expansionary monetary policy is measured by a reduction in the
funds rate or an increase in no borrowed reserves. This conflict may be the result of the
constant velocity of money under the Cash-in-Advance constraint. With Marshall’s (1992)
transaction cost justification for money, money velocity responds to a change in short-term
interest rates. This response would create a positive correlation between real stock returns and
the quantity of money. Basistha and Kurov (2008) found out that the coefficient estimates of
the stock responses in bull market range from -31.96 to 28.85, with a mean of -0.83 and
median of - 0.66. Less than 13% of these coefficient estimates are statistically significant at
the 10% level or better. For bear markets, the range of the coefficient estimates is from -59.14
to 17.82, with a mean of -10.84 and median of -8.13. Over 62% of these estimates are
18 | P a g e
statistically significant at the 10% level or better, including 21 positive coefficient estimates.
17 of the 21 firms that show significant positive responses to monetary news in bear markets
are non-durable goods firms, utilities or energy firms. The distribution of bear market
responses is skewed to the left. In bull markets, sensitivities to the term spread factor and
sentiment have no statistically significant effect on the impact of target rate changes on stock
returns. This finding is consistent with monetary shocks having little effect on stocks in good
times. The OLS regression R squared is about 0.76, compared to only 0.03 for the bull market
results. According to the theories of the credit channel of monetary transmission, firms that
are relatively financially constrained should be most affected by monetary shocks in bad
economic times because such shocks affect their access to credit.

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 CHAPTER 3
RESEARCH METHODOLOGY

3.1 Introduction
This study is designed to analyze the effects of monetary policy on Indian stock
market performance. Its primary objective is to correctly establish the way in which monetary
policy affects the stock markets. It further seeks to determine the extent to which changes in
money supply, interest rates and inflation rate affect growth of stock market capitalization
over the short, medium and long run period in the country. The data used for this research is
obtained from the World Bank, RBI website, the International Financial Statistics, a
publication of the International Monetary Fund (I.M.F) and NSE India. For the purpose of
this research work, secondary data was collected and used. The variables used are: growth
rate of money and quasi money supply, lending rate, inflation rate at consumer price and
stock market capitalization. The data collected covers the period between 2003 and 2013. For
the purpose of our analysis, the variables used to measure the effects of monetary policy on
stock market performance are broad money (M3), Foreign Institutional Investments (FII),
inflation rate at consumer price index and market capitalization. These variables are included
in our regression model. Many economists believe that other factors affect stock market
performance such as investors’ confidence, fiscal policy amongst others.

Market Capitalization: Market capitalization (also known as market value) is the share
price times the number of shares outstanding or issued. It is the market value of a company’s
issued shares. Market capitalization is the total value of all equity securities listed on a stock
exchange. It is a function of the prevailing market price of quoted equities and the size of
their issued and paid up capital. Listed domestic companies are the domestically incorporated
companies listed on the country's stock exchanges at the end of the year. Listed companies do
not include investment companies, mutual funds, or other collective investment vehicles. But
here the CNX Nifty index has been taken as the measure of market capitalization.

Broad Money: In economics, broad money is a measure of the money supply that includes
more than just physical money such as currency and coins (also termed narrow money). It
generally includes demand deposits at commercial banks, and any monies held in easily

20 | P a g e
accessible accounts. Components of broad money are still very liquid, and non-cash
components can usually be converted into cash very easily.
The most commonly used measure of broad money is M3, which includes currency and
coins, and deposits in checking accounts, savings accounts and small time deposits,
overnight repos at commercial banks, and non-institutional money market accounts. This is
the main measure of the money supply, and is the economic indicator usually used to assess
the amount of liquidity in the economy, as it is relatively easy to track

Foreign Institutional Investment (FII): The term is used most commonly in India to refer to
investment or outside companies investing in the financial markets of India. International
institutional investors must register with the Securities and Exchange Board of India to
participate in the market. One of the major market regulations pertaining to FIIs involves
placing limits on FII ownership in Indian companies. Despite the lacklustre state of the Indian
economy, foreign investors have not stopped pumping money in the domestic stock market.
Last year, FIIs poured in Rs 1.13 lakh crore, and after the September quarter, the FII
ownership in Indian stocks is at its highest level. The aggregate holding of FIIs in the
benchmark Nifty companies was 17.69 per cent in the September quarter, compared with
16.19 per cent in the same period last year.
The inflow of foreign money is largely responsible for determining the direction of
not only individual stocks, but also the Indian equities as a whole. Hence, investors need to
be aware of FII activities. They mostly invest in the frontline stocks that constitute the Nifty
or Sensex. Given this narrow universe of stocks, FII ownership in this basket has now
become bloated. Currently, FIIs own huge stakes in prominent blue chips. In the September
quarter, the FII stake in companies such as Axis Bank, M&M, HCL Technologies, Tata
Power Company, NTPC, Wipro and Sun Pharma hit a record high. In fact, FII ownership in
many frontline stocks like ITC and TCS is close to hitting the ceiling.

Inflation Rate: Inflation as measured by the consumer price index reflects the annual
percentage change in the cost to the average consumer of acquiring a basket of goods and
services that may be fixed or changed at specified intervals, such as yearly. The Laspeyres
formula is generally used in its computation. While inflation rate is not a monetary policy
tool, it is an intermediate target of monetary policy and monetary policy in most countries is
usually adopted to achieve price stability which entails maintaining low inflation.

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3.2 Objectives
The specific objectives of the study include to:
 Examine the trend of stock market performance and how variations in growth of
market capitalization in one period affects itself in another period.
 Determine the influence of monetary policy changes on stock market performance in
the long run.
 Analyse the impact of FII shocks on stock market performance in the long run.
 Explain the effects of inflation rate shocks on stock market performance in the long
run.

3.3 Hypothesis Formulation

For the purpose of this research, it is pertinent to make some hypotheses and postulations
which would generally give direction to the study and to arrive at valid, reliable and testable
conclusions. Therefore, the following null hypotheses are to be tested:
 Growth of money supply has no significant long run impact on stock market
performance.
 Growth in FII has no significant long run impact on stock market performance.
 Inflation rate has no significant long run effect on stock market performance.

3.4 Model
Based on the above theoretical framework, we can go ahead to specify our model. To
specify the model for this research work, we consider the variables of monetary policy and
FII which are the exogenous variables or independent variables in this model and the variable
representing stock market performance which is the endogenous variable or dependent
variable. In this model, we express growth rate of stock market capitalization (M) as a
function of broad money growth (G), FIIs growth (F) and inflation rate (I). Growth rate of
market capitalization is obtained by taking the log of market capitalization.
Therefore, the functional relationship between the variables is expressed as follows:
Mt= f (Gt, Ft,, It)

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For the vector autoregression, the reduced forms VAR methodology is used.
The equations for the four variables are specified as follows:

Growth Rate of Market Capitalization

FII growth

Broad Money Growth

Inflation Rate

Where
Mt , Gt , Ft and It are (nX1) vectors representing forecast values of growth of market
capitalization, broad money growth, FII growth and inflation rate respectively.
b0i , b1i , b2i , b3i and b4i are (nXn) matrices of coefficients
Mt-I , Gt-I , Lt-i and It-i are (nX1) lagged values of growth of market capitalization,
money and quasi money growth, lending rate and inflation rate
u1t, u2t, u3t and u4t are a (nX1) vector of uncorrelated white noise disturbances.

23 | P a g e
The vector error correction model (VECM) equation can be specified as follows:

Where
 ΔMt is a vector of a stationary endogenous variable (growth rate of market
capitalization)
 ΔGt, ΔLt , and ΔIt are vectors of stationary exogenous variables including seasonal
dummies, α0, α1, α2, α3, α4 with the exogenous variables, et-1 in both equations are
error correcting terms while μt is the random or stochastic error terms..

The parameters measure the speed at which the variables in the system adjust to
restore a long-run equilibrium, and the vectors are estimates of the long-run cointegrating
relationships between the variables in the model. This research work shall make use of
descriptive and econometric techniques of analysis. The descriptive techniques are carried out
using tables. The tables would clearly present the data and thus enhance comparison of the
variables in the study. The empirical or econometric technique which will be used in this
study is Vector Error Correction Model (VECM). Using the VECM technique, impulse-
response and variance decomposition analysis would be performed on the data.

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 CHAPTER 4
DATA ANALYSIS AND INTERPRETATION

4.1 Time Series Properties Of Data

Stationarity and Unit Root Tests
Unit root tests are important in order to perform regression analysis of time series data
because they exhibit non-stationary behaviour in their level form. This poses a serious
potential threat to econometric analysis and often leads to spurious results if the appropriate
adjustments are not carried out. To guard against spurious regression results, this study
checks the stationarity of the variables using the Augmented Dickey-Fuller unit root test
developed by Dickey and Fuller (1981). The Dickey-Fuller Unit Root Tests are based on the
following three regression forms:
1. Without Constant and Trend: ΔYt = δYt-1 + Ut
2. With Constant: ΔYt = α + δYt-1 + Ut
3. With Constant and Trend: α + βT + δYt-1 + Ut
The hypothesis is:
H0: δ=0 (unit root exists or data are non-stationary)
H1: δ≠0 (unit root does not exist or the data are stationary)
Decision rule:
If t* > ADF critical value, ==> accept null hypothesis and conclude that unit root exists.
If t* < ADF critical value, ==> reject null hypothesis, conclude that unit root does not exist.

Without constant With constant With constant and trend

Mkt_gth 0.09958 0.2932 0.3053
Money_gth 0.5106 0.8263 0.934
FII_gth 0.1643 0.1858 0.392
Inflation 0.8782 0.7342 0.8674
Table 4.1: ADF Test for level of variable

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 Without constant With constant With constant and trend
Mkt_gth 0.0009924 0.01532 0.07086
Money_gth 0.006887 0.0787 0.02752
FII_gth 0.001208 0.0161 0.06435
Inflation 0.004987 0.02724 0.08958
Table 4.2: ADF Test for first difference of variable

Thus we observe that all the t* > ADF critical value (5% or 10%) in their level of variable
and thus are non-stationary but t* < ADF critical value (5% or 10%) for the first difference of
the variable, thus variable are stationary in their first difference i.e. I(1).

26 | P a g e
4.2 Regression Result
In order to determine the effects of monetary policy on stock market performance, the
model specified in chapter three is estimated using the technique of Vector Error Correction
Model (VECM). The vector autoregression (VAR) model is a general framework used to
describe the dynamic interrelationship between stationary variables. So, the first step in your
analysis should be to determine whether the levels of your data are stationary. If not, take the
first differences of your data and try again. Usually, if the levels (or log-levels) of your time-
series are not stationary, the first differences will be.
If the time-series are not stationary then the VAR framework needs to be modifed to
allow consistent estimation of the relationships among the series. The vector error correction
model(VECM) is just a special case of the VAR for variables that are stationary in their
differences (i.e.I(1)). The VECM can also take into account any cointegrating relationships
among the variables. The lags are selected by using the minimum of the Akaike Information
Criteria (AIC), Schwartz-Bayesian Information Criteria (SBIC) and Hannan-Quinn Criteria
(HQC). The results of the VECM estimation are presented along with their impulse response
functions and graphs and variance decomposition functions. This was performed using gretl
statistical software. An impulse response function traces the effect of one standard deviation
shock to one of the innovations on current and future values of the endogenous variables.
Generally, the response function shows the responses of a particular variable to a one-time
shock to each of the variables in the system (Ajilore, 2002). The study examines market
growth as the response variable and examines the effects of one standard deviation shock of
growth of broad money supply, FII growth rate and inflation rate on growth of market
capitalization. However, the impulse response graph shows the result when all the variables
are taken as impulses and as response variables.
The forecast variance decomposition measures the degree of the variation of each of
the variables to its own shocks and shocks from other variables in the model. Again, in order
to reduce the size of this work, it only examines the decomposition of variance of growth of
market capitalization (Mkt_gth) to its own shocks and shocks from growth of broad money
supply, FII growth rate and inflation rate.

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4.2.1 VECM analysis
VECM system, lag order 24
Maximum likelihood estimates, observations 2005:01-2013:08 (T = 104)
Cointegration rank = 3
Case 2: Restricted constant
beta (cointegrating vectors, standard errors in parentheses)
Mkt_gth 1.0000 0.00000 0.00000
(0.00000) (0.00000) (0.00000)
Money_Growth 0.00000 1.0000 0.00000
(0.00000) (0.00000) (0.00000)
FII_gth 0.00000 0.00000 1.0000
(0.00000) (0.00000) (0.00000)
Inflation 0.26911 0.093321 0.067303
(0.11514) (0.025776) (0.096798)
const -3.7610 -2.0707 -2.4731
(0.94767) (0.21216) (0.79673)

alpha (adjustment vectors)

Mkt_gth -6.4523 13.638 9.2277

Money_Growth -0.17028 -1.6871 0.18569
FII_gth 1.6206 -6.6626 -4.7366
Inflation 0.063536 -1.4999 -0.69715

Log-likelihood = -189.98508
Determinant of covariance matrix = 0.00045375684
AIC = 11.0382
BIC = 20.8021
HQC = 14.9938

Mean dependent var -0.115751 S.D. dependent var 11.11057

Sum squared resid 255.2613 S.E. of regression 5.648687
R-squared 0.979926 Adjusted R-squared 0.741551
rho -0.022055 Durbin-Watson 2.021036
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Cross-equation covariance matrix:
Mkt_gth Money_Growth FII_gth Inflation
Mkt_gth 2.4544 -0.044736 -0.36713 -0.081278
Money_Growth -0.044736 0.036065 -0.15200 0.013942
FII_gth -0.36713 -0.15200 0.95972 -0.12644
Inflation -0.081278 0.013942 -0.12644 0.070393
Table 4.3: Cross-equation covariance matrix:
determinant = 0.000453757
Note: The equation of Mkt_gth is given in the appendix

4.2.2 Impulse response function of Market growth

Period Money growth FII growth Inflation rate
1. 0.00000 0.00000 0.00000
2. -1.1258 0.74914 -0.15094
3. -0.24264 0.49166 -0.43560
4. -0.21289 0.29246 -0.10927
5. -0.81350 1.3266 -0.92033
6. 0.25739 -0.25046 0.44435
7. -0.13001 -0.33282 0.60586
8. -0.27620 0.40537 -0.48154
9. -0.53248 0.41665 0.016621
10. 0.26588 0.44918 -0.72332
11. -0.49312 -0.092912 0.24626
12. -0.032521 0.32740 -0.38715
13. 0.42004 0.19319 -0.45087
14. 0.0068926 -0.25698 0.14531
15. 0.23265 -0.36378 0.28222
Table 4.4: Response on Market growth due to one standard shock in three variables

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 One std. shock in Money growth
0.6
0.4
0.2
Market growth response

0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
-0.2
-0.4
-0.6
-0.8
-1
-1.2
-1.4
Period in months

Figure 4.1: Response on Market growth due to one standard shock in money growth
The table and the graph above depicts the impulse response of growth rate of market
capitalization of the model for India using a horizon of 15 months.The above figure shows
that when there is change in money growth due to changes in policy i.e. CRR, SLR, Repo
rate it effects stock market negatively in the short run (period 1 to 5) and gradually market
adjusts to it and impact is positive in the long run.

One std. shock in FII growth

1.6
1.4
Market growth response

1.2
1
0.8
0.6
0.4
0.2
0
-0.2 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
-0.4
-0.6
Period in months

Figure 4.2: Response on Market growth due to one standard shock in FII growth
The above figure shows that when there is change in FII growth due to changes in invertor
sentiments, favorable domestic conditions it effects stock market positively in the short run

30 | P a g e
(period 1 to 5) and long run. Market gradually market adjusts to the change in the 14-15th
period.

One std. shock in Inflation rate

0.8
0.6
Market growth response

0.4
0.2
0
-0.2 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
-0.4
-0.6
-0.8
-1
Period in months

Figure 4.3: Response on Market growth due to one standard shock in inflation rate

In the case of inflation rate as the impulse variable, the response of growth of market
capitalization a one standard deviation shock to lending rate was negative in the first five
periods but is generally oscillating and requires time to adjust to the change in sudden
volatility in prices.

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4.2.3 Decomposition of variance for Market growth
120

100

80
Variance

Mkt_gth
60
Money_Growth
FII_gth
40
Inflation

20

0
1 4 7 10 13 16 19 22 25 28 31 34 37 40 43 46 49 52 55 58 61 64 67 70 73
Period in months

Figure 4.4: Decomposition of variance for Market Capitalization (growth)

Note: The table is provided in Appendix for futher reference

The figure above presents the results of variance decomposition of growth of market
capitalization for India over a 75 month simulation period. The predominant source of
variation of growth of market capitalization is the “own” shocks in the short run but in the
long run, broad money growth account more for variations in growth of market capitalization.
The growth of market capitalization accounted for 100% of its own forecast error variance in
the first month. This however gradually declined to 33.35% in the 75th month. Initially FII
growth played bigger role than broad money and inflation from 4th to 23rd month but then had
lesser influence in the long run. Inflation rate performed very weakly both in the short run
and long run, its contribution remained steady around 12-15%.
Thus it can be inferred that FII affect Indian stock markets in the short run which is
evident from the 2008 financial crisis when FIIs took their money out from the stock market
and nifty index tanked 50% from 6000 in a year. Also monetary policy becomes the
predominant source of variation of growth of market capitalization in the long run.

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 CHAPTER 5
CONCLUSION AND POLICY RECOMMENDATIONS

5.1 Conclusion
Based on the analysis performed above and the impulse response graphs drawn, it can
be interpreted that money growth in addition to market growth is the major determinant of
stock market performance since it is the major variable that determines stock market
performance in the long run. This is followed by FII growth and inflation rate which were
secondary determinant affecting the stock market of India. The short run, medium run and
long run equilibrium relationships between the four variables has been examined and these
would be useful in giving appropriate policy recommendations to central bankers for better
formulation of monetary policy for stock market stability and growth. The three hypotheses
of the study were rejected based on the evidence provided by our analysis because broad
money growth, FII growth and inflation rate all had significant long run relationships with
stock market performance. Inflation rate did not really influence much variation in stock
market performance contrary to many of the literature reviewed, but stock markets still
responded to changes in inflation rate. This research work postulates that stock market factors
(such as investors’ confidence) and money supply in the economy are the major determinants
of stock market performance.
In conclusion therefore, central bank officials should make conscious effort to
determine the principal determinants of stock market performance in their various countries
and implement appropriate policies that would enhance the development of their stock
markets. The “one rule fits all” notion has been shown to be invalid in this study as what
works in one country may fail in another. Ioannidis and Kontonikas (2006) asserted that the
existence of a relationship between monetary policy and stock market performance has
important implications for both stock market participants and central bankers since, with
respect to the former, this issue relates to the broader topic of stock price determination and
portfolio formation; while the latter are interested in whether monetary policy actions are
transmitted through financial markets. Monetary policy makers i.e. RBI have to pay close
attention to this relationship in order to formulate policies that would lead to long run growth
and stability of financial markets in general and the stock market in particular.

33 | P a g e
5.2 Policy Recommendations
Based on the results obtained from this study and the literature review, following policy
recommendations and options can be made which central bank officials and other monetary
policy formulators can apply in order to enhance stock market performance.

1. According to Chami, Cosimano and Fullenkamp (1999), understanding the monetary

transmission mechanism is essential to policymakers because different mechanisms
may imply that different targets are optimal or appropriate. The stock market channel,
for example, suggests that the price level is the appropriate target of monetary policy;
the money channel and the creditworthiness channels imply that the interest rate
should be targeted; the bank-dependent borrower channel suggests the quantity of
credit. Therefore, policymakers as a matter of necessity should fully understand the
appropriate mechanism operational in their country and the channel through which
monetary impulses affect stock market performance.

2. Central bankers and stock market participants should be aware of the relationship
between monetary policy and stock market performance in order to better understand
the effects of policy shifts. Monetary authorities in particular face the dilemma of
whether to react to stock price movements, above and beyond the standard response to
inflation and output developments. There is an ongoing debate in the monetary policy
rules literature between the proactive and reactive approach. On the one hand, the
proactive view advocates that monetary policymakers should alter interest rates in
response to developing stock price bubbles in order to reduce overall macroeconomic
volatility (see Cecchetti et al. (2000); Kontonikas and Ioannidis, ( 2005). On the other
hand, according to the reactive approach, monetary authorities should wait and see
whether the stock price reversal occurs, and if it does, to react accordingly to the
extent that there are implications for inflation and output stability. Hence, the reactive
approach is consistent with an accommodative ex-post response to stock price
changes (see Bernanke and Gertler, 1999, 2001). It is apparent then, that the empirical
verification of the effect of monetary policy on stock market performance is important
for monetary policy formulation.

3. The central bankers can improve economic performance by paying attention to asset
prices. The stock market is one of the most important financial institutions operating
34 | P a g e
 in an economy and this makes it very necessary for the apex regulatory financial
institution to monitor its activities in order to achieve stability and maintain
development over the long run. The central banks of all countries of the world should
adequately regulate stock market activities in order to maintain their transparency.
Also, stock market officials should work hard to reduce the frequency of asset price
bubbles which do not help stock market development in the long run.

4. The stock market operates in a macroeconomic environment and thus its performance
is very dependent on investors’ confidence and the general perception of the health of
the economy. Therefore, monetary policymakers need to make the environment
enabling and free of fear in order to bring about development of the stock markets.
They also need to take into account speculations going on in the economy and
incorporate these speculations into their formulation framework.

5. The volatility of stock markets to policymakers’ activities is evident on a daily basis

especially on days when policymakers meet to make decisions on proposed changes
to monetary policy. Policymakers should obtain adequate and reliable information on
the stock market’s present stance before taking action to avoid depressing the stock
markets. They should also be able to anticipate and forecast what effects policy would
have on stock markets in the long run so that inside and outside lags that plague
monetary policy would not render policies ineffective. Furthermore, policymakers
should be consistent in their policy formulation. Inconsistencies in the policies bring
about uncertainty and this will not be healthy for the development of the stock
markets in the long run.

6. Bernanke and Gertler (2000) argue that central banks should intervene in financial
markets to the extent that they affect aggregate demand. From the perspective of
policymakers, liquidity assistance from a lender of last resort can be very important in
preventing a larger meltdown in financial markets and reducing the probability of a
future financial crisis that can have real economic effects. Bernstein, Hughson and
Weidenmier (2008) interprete their results as strong evidence that the introduction of
a lender of last resort significantly reduced the probability of a financial crisis and its
potentially negative effects on economic activity, especially in the fall harvest
months. Policymakers should make use of instruments such as bail-outs and interest
35 | P a g e
 rate reductions in times of crisis to rescue stock markets which can barely help
themselves in such periods.

7. Central banks also need to recognize their limitations and not attempt to do too much
so as not to overheat the economy and worsen it. There is a limit to which monetary
policy can be effective in affecting stock market performance and beyond this limit,
any attempt to further use monetary policy to influence stock markets would be
ineffective at best or harmful in adverse circumstances.

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 BIBLOGRAPHY
References to articles
 Adkins, Lee.C. (2010) “Using gretl for Principles of Econometrics 3rd Edition
Version 1.313.
 Ajilore, Olubanjo Taiwo (2002) “Financial Sector Reforms and Efficiency of
Financial Intermediation in Nigeria: Statistical Evidence.” Ife Journal of Economics
and Finance. Vol. 5 (1 and 2).
 Banerjee, Prashanta K. and Adhikary, Bishnu.K. (2006) “Dynamic Effects of Interest
Rate and Exchange Rate Changes on Stock Market Returns in Bangladesh.” pp 1-26.
 Basistha, Arabinda and Kurov, Alexander. (2008) “Macroeconomic Cycles and the
Stock Market’s Reaction to Monetary Policy.” pp 1-33.
 Bernanke, Ben S. and Kuttner, Kenneth N. (2004) “What Explains the Stock Market’s
Reaction to Federal Reserve Policy?” NBER Working Paper Series. Working Paper
10402. pp 2-18.
 Bordo, Michael D.; Dueker, Michael J. and Wheelock, David C. (2007) “Monetary
Policy and Stock Market Booms and Busts in the 20th Century.” Federal Reserve
Bank of St. Louis Working Paper Series. Working Paper 2007 020A. pp 3-30.
 Chami, Ralph; Cosimano, Thomas F. and Fullenkamp, Connel. (1999) “The Stock
Market Channel of Monetary Policy”. IMF Working Paper WP/99/22. pp. 1-15.
 Günsel, Nil and Çukur, Sadik (2007) “The Effects of Macroeconomic Factors on the
London Stock Returns: A Sectoral Approach.” International Research Journal of
Finance and Economics. Issue 10 (2007) pp 1-13
 Kontonikas, Alexandros and Kostakis, Alexandros (2007) “On Monetary Policy and
Stock Market Anomalies.” pp 1-20.
 Kurov, Alexander (2009) “Investor sentiment and the stock market’s reaction to
monetary policy.” Journal of Banking and Finance. pp 1-20.
 Mishkin, Frederic S. and White Eugene N. (2002) “U.S. Stock Market Crashes and
their Aftermath: Implications for Monetary Policy.” NBER Working Paper Series.
Working Paper 8992. pp 1- 10.
 Mehar Ayub (2000) “Stock market consequences of macroeconomic fundamentals.”
MPRA Paper No. 442. pp 1-19.
 Sellin, Peter. (1998) “Monetary Policy and the Stock Market: Theory and Empirical
Evidence.” pp 2-30.

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Reference to Books:
 Gujarati, Damodar N. (2004) “Basic Econometrics.” Fourth Edition. McGraw Hill
Press Inc.
 Blanchard, Olivier (2006) “Macroeconomics.” Fourth Edition. Pearson Education,
Inc.
 Cecchetti, Stephen G. (2008) “Money, Banking and Financial Markets.” Second
Edition. McGraw- Hill International Edition.

Reference to websites:
 http://data.worldbank.org/
 http://www.nseindia.com/
 http://www.rbi.org.in/
 http://espin086.wordpress.com/2011/04/02/the-impact-of-unexpected-shocks-to-the-
u-s-economy-impulse-response-functions-revisitedirf/

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Appendix 1
Decomposition of variance for Market Capitalization (growth)
Period(months) Mkt_gth Money_Growth FII_gth Inflation

1 100 0 0 0

2 66.3946 23.0047 10.1871 0.4135

3 61.6598 21.714 13.1465 3.4797

4 60.2937 21.9196 14.1994 3.5873

5 42.7059 20.2492 26.3744 10.6705

6 46.4575 18.4907 23.8765 11.1753

7 46.2188 17.3137 23.0843 13.3832

8 48.2896 16.0907 21.9131 13.7066

9 47.1472 17.4407 22.2547 13.1574

10 45.7563 16.6458 21.9694 15.6285

11 44.978 17.8256 21.5313 15.6651

12 45.0436 17.2928 21.5439 16.1197

13 43.9435 17.9118 21.2137 16.931

14 43.7286 17.8135 21.4934 16.9645

15 43.4839 17.7145 21.7668 17.0349

16 40.3173 17.6412 23.4727 18.5688

17 42.3456 17.5894 22.514 17.5511

18 45.8146 16.7909 21.09 16.3045

19 45.0617 16.4873 22.338 16.1131

20 43.2161 19.5802 22.0541 15.1497

21 43.9095 19.2727 21.8375 14.9802

22 45.1871 18.7661 21.2725 14.7742

23 46.6645 18.4643 20.6003 14.271

24 44.1807 21.7012 19.6413 14.4768

25 44.1735 21.4854 19.9918 14.3493

26 43.7382 21.4298 20.641 14.191

27 44.539 21.4941 20.0895 13.8774

28 43.0747 23.4421 19.9503 13.5329

29 45.072 22.7914 19.2288 12.9077

30 43.3407 22.3485 19.7327 14.5782

31 42.6164 22.2305 20.2631 14.8899

32 42.7896 22.0891 20.34 14.7813

33 42.7588 22.072 20.3189 14.8503

34 42.2541 21.8231 20.5734 15.3494

35 42.0524 22.2724 20.3823 15.293

36 41.8905 22.3728 20.3419 15.3949

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 37 41.174 22.5468 20.7081 15.5711

38 40.9459 22.9371 20.6632 15.4538

39 40.8464 22.813 20.9463 15.3944

40 39.6613 22.1512 21.7487 16.4388

41 39.3635 22.6698 21.5029 16.4638

42 39.9831 22.5424 20.699 16.7756

43 40.9304 22.6636 20.0264 16.3796

44 40.7954 22.7778 19.9107 16.516

45 40.6105 22.853 19.9932 16.5433

46 40.3049 22.8474 20.4387 16.409

47 38.7788 24.364 20.2136 16.6436

48 38.3233 25.5174 19.8167 16.3426

49 39.4304 27.5101 17.9722 15.0872

50 39.5646 26.5032 18.2734 15.6588

51 39.3677 27.7372 17.7099 15.1852

52 36.5193 32.7429 16.5427 14.195

53 36.5184 32.8102 16.6176 14.0538

54 35.1842 31.1806 18.3673 15.2679

55 35.4851 31.8042 17.9735 14.7371

56 35.3739 32.1149 17.8462 14.665

57 35.0678 32.2783 18.0527 14.6011

58 34.0371 31.4103 19.5234 15.0291

59 34.0187 32.0334 19.159 14.7889

60 34.5664 32.2352 18.599 14.5994

61 36.9398 30.8955 17.9803 14.1843

62 35.9957 33.4158 17.0785 13.51

63 34.1918 37.2867 15.6802 12.8413

64 33.3671 35.2887 17.8324 13.5118

65 33.4553 33.4668 18.9572 14.1207

66 32.1832 36.5737 17.9954 13.2477

67 31.9104 36.5578 18.3677 13.1642

68 30.2169 34.6786 21.1077 13.9968

69 30.4763 34.4654 21.1471 13.9113

70 30.7643 34.9518 20.6901 13.5938

71 31.4405 36.061 19.6085 12.89

72 33.6067 34.8842 19.0306 12.4785

73 32.0358 37.4372 18.1363 12.3908

74 31.4896 40.1528 16.8183 11.5393

75 33.3589 37.9096 17.2785 11.453

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