Exploring Monetary Policy and Stock Market (Dissertation Sample)

SCHOOL OF ECONOMICS AND FINANCE
ECOM 146 Empirical Finance
An Empirical Project
Dissertation Tittle: Monetary Policy and Stock Market.
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ABSTRACT.
This study presents an evaluation of stocks and monetary policy to empirically analyse and understand their relationship. The underlying hypothesis is that movements in the stock market leads to changes in monetary policy. The study will hence test the hypothesis for the arguments for and against it. The research area is important to investigate because of the underlying impact of monetary policy on a country’s economy and allocation of economic resources over the equity market. In doing so, the study evaluate the monthly data from the UK economy which ranges from the Quarter one (Q1) of 1990 to Q4 2010. Variables constructed in the study tests the existence of a relationship in stock movements and determination of monetary policy. The variables used in the data analysis includes the UK RGDP, CPI, UK LSE (FTSE all stock index), as well as the interest rates, (Central Bank in UK).
For research purpose, the asset pricing model forms a theoretical foundation of the research where asset price volatility (which takes into account the analysis variables), is assumed to affect monetary policy since it brings additional data to the authorities making the monetary policy, (Cecchetti, et al, 2002). To examine this relationships in the market, the simple Taylor rule where the OLS equation analysis on E-views statistical package was used to analyse the variables. The results showed a positive level of significance between the information brought by assets price volatility to the model at p < 0.07. The results tried to show that when the prices of assets increases, the market interest rates also increases. A Wald test of the equation to reject the null hypothesis using E-view shows the weight of inflation affects monetary policy more than the output weight. The interest rates used by the monetary authorities to regulate the economy are seen to be triggered by the used model variables. The empirical evidence therefore supported the proposition or the reaction of monetary policy to stock movements in the market. Hence, monetary policy is adjusted to help maintain a stable economy depending on stock movements. The findings of this report are useful and could be used by economic regulators in setting and adjusting monetary policy according to the movements in stock markets.
Contents TOC \o "1-3" \h \z \u ABSTRACT. PAGEREF _Toc35124323 \h 2CHAPTER ONE: INTRODUCTION PAGEREF _Toc35124324 \h 31.1 Topic. PAGEREF _Toc35124325 \h 31.2 Statement of the Problem. PAGEREF _Toc35124326 \h 31.3 Background and Theoretical Framework PAGEREF _Toc35124327 \h 41.2 Structure of the Dissertation PAGEREF _Toc35124328 \h 5CHAPTER TWO: LITERATURE REVIEW PAGEREF _Toc35124329 \h 62.1 Introduction. PAGEREF _Toc35124330 \h 62.2 Monetary Policy and Stock Market Activity PAGEREF _Toc35124331 \h 62.3 Scholarly Review. PAGEREF _Toc35124332 \h 62.4. Conclusion PAGEREF _Toc35124333 \h 9CHAPTER THREE: RESEARCH METHODOLOGY PAGEREF _Toc35124334 \h 103.1 introduction PAGEREF _Toc35124335 \h 103.2 Empirical Economic model Framework. PAGEREF _Toc35124336 \h 103.2.1 Model Background PAGEREF _Toc35124337 \h 103.2.2 Model Technique Used PAGEREF _Toc35124338 \h 113.2.2.1 First Equation Estimation: Simple Taylor rule PAGEREF _Toc35124339 \h 113.2.2.2 Variables Testing PAGEREF _Toc35124340 \h 123.2.2.3 Diagnostic Testing. PAGEREF _Toc35124341 \h 133.2.2.4 Second Equation Estimation: Augmented Taylor rule PAGEREF _Toc35124342 \h 133.3 Data Description PAGEREF _Toc35124343 \h 13CHAPTER FOUR: DATA ANALYSIS. PAGEREF _Toc35124344 \h 164.1 Introduction PAGEREF _Toc35124345 \h 164.2 First model: Simple Taylor Rule. PAGEREF _Toc35124346 \h 164.3 Second model: Augmented Taylor Rule. PAGEREF _Toc35124347 \h 19CONCLUSION PAGEREF _Toc35124348 \h 23REFERENCES PAGEREF _Toc35124349 \h 24APPENDIX PAGEREF _Toc35124350 \h 26
INTRODUCTION
1.1 Topic.
The chosen topic for this dissertation is Monetary Policy and Stock Market. The key words are the Stock Market (ST) and Monetary Policy (MP).
1.2 Statement of the Problem.
The role played by stock market is important in maintaining economic stability of a country. Movements in stock markets directly implicates some changing conditions in a country’s economy. These movements are controlled by monetary policy, often overseen by the country’s Federal Reserve or The Central Bank to maintain a stable economy. Therefore, there is a direct connection between the movements in the stock markets with the response on monetary policy. For instance, increasing share prices tend to be associated with successful investments, the increasing prices also tend to influence other factors in the economy such as households wealth and increased consumptions. These among many other factors may trigger such macroeconomic factors such as inflation increase which need to be controlled using monetary policy. Hence, movement in stock market triggers economic factors, both on demand and supply side, which in return will bring about monetary policy responses through Federal Reserves and The Central Banks.
1.3 Background and Theoretical Framework
The study will focus on the analysis of the response of monitory policies to stock market movements in an economy. The dissertation will take a case study for UK economy and analyse the Monitory policies responses to the movements in stock market for the period between Q1 of the year 1990 to the fourth quarter (Q$) 2010. By monetary policy, it means the manner in which a country controls its economy through money supply and interest rates using its Federal Reserve or The Central Bank. A country does this in order to achieve major goals in its economy such as increase and maintain employment creation, enhance stability of commodity prices in the country and a stable economy growth among many others. A country’s economy will have reactions on the movements of the stock prices where in case there are many and major unstable movement in exchange rates, housing and stock market, the economy experiences bust and booms at prolonged rates, (Petersen, 2007). All these need to be controlled using the monetary policy failure to which the economy may recess and crash the stock market indefinitely. The Federal Reserve or the Central bank will therefore prevent this using monetary policy that are favourable to the economy. According to the key area focused in this study, stock market connect the major forces of the economy due to its influence on the basic activities that determines the movement of an economy such as decisions to invest, to save and to consume, (Gregoriou, et al, 2009).
While the Keynesian theory of Economics show that fiscal or monetary policy are best used drivers that can be used to control the macroeconomic environment of an economy (Ayopo, et al, 2015), some empirical evidences from the report have shown direct connection in stocks movements and determining monetary policies. MPC (Monetary-Policy-Committee), the body that sets monetary policy in UK under Bank of England, has reportedly been using and monitoring London Stock Exchange (LSE) data in setting some key monetary policy such as interest rates. Monetary Policy Committee also heavily relied on stock movements when it was employing Quantitative Easing as part of its monetary policy in the period 2008 to 2009, (Fischbacher, et al, 2013).
The above relationships shows the connections in stock market movements and the response of monetary policy to control economic response to stock variations. This study will hence experiment a hypothesis that monetary policy will always respond to this movement and will in details evaluate the argument against and for the set hypothesis.
1.2 Structure of the Dissertation
The desertion contains the following sections,
* Review of Literature. The part will critically examine the importance of the chosen research topic and present the research question that the study will be answering. It will also discuss the method used to analyse the research data. The section will then evaluate earlier research work that has been carried under this topic, criticize and review the economic theories that applies to the topic then conclude with a summary of the study findings.
* Data Description and Methodology. This section will summarize the data used in the research and models and methods used for analysis
* Data Analysis. The section will present detailed empirical evaluation of the data and present the resulting outcome.
* Conclusion. This final section will present summarised findings from the empirical analysis. The results of these findings will then be connected and compared with the introduction arguments and specifically indicate what the relationship mean.
REVIEW OF THE LITERATURE
Introduction.
This is an empirical research to evaluate the relationship in movements in stock market and monetary policyit is useful because of the importance of monetary policy in maintaining balanced and stable economy. Stable economy provides the best environment for investors and business growth. Investing in the stock market is a key activities that most investors undertake and also most business participate in share offering, (Goto, and Valkanov, 2002). Hence, there is an important relation that is supposed to be investigated between share price movements in stock market and the MP. Also, a relationship exists between an attempts to change the monitory policy by the regulators to react to the reaction of the stock market. Hence, these re...