The Objectives of the Monetary Policy Finance Essay

The key purpose of bringing specific change in monetary policy is maintaining the Gross domestic product (GDP) strong by maintaining the inflation low and controlling the interest rate alterations. It is known that the interest rates and quantities of money can be affected by the tools available to central banks, that has direct effects on interest rates and quantities of money and they just impact the ultimate policy objectives. The government used to set the interest rates in earlier days before May 1997, and then its controlling authority was passed to the Bank of England The Bank defines the targets for interest rate and inflation to their most appropriate levels for unproblematic achievements under the Bank of England Act 1998. According to Glenn Hoggarth (1996) [1] "Changes in Central Bank interest rate (i.e. monetary policy) affect the whole spectrum of interest rates in the economy, particularly at the short end but also at longer maturities." However, it also depicts that the interest rate change effect is vague because banking system interest cannot be controlled by the central bank. It is quite obvious that the changes made on interest rate by the central bank, it definitely impacts on other banks and financial institutions interest rates. Firms' cash flows are affected by lowering the level of interest rate hence resulting in the decreased interest payments on loans. Gertler and Gilchrist (1994) argue that "a monetary tightening, by increasing interest rates, can worsen cash flow net of interest and thus firms' balance sheet positions". Hence, the firm's capacity to borrow and invest can lessen because of the declination in net worth, resulting in varying the financial assets prices comprises of equity and bonds (i.e. lower interest rates increase the prices of shares) 2. Monetary policy and business condition variables: Financial economics purely believe on goals of considering the pragmatic association between macroeconomic variables such as unemployment, real output, inflation and economic policy action i.e. central bank changes on discount rate. Numerous researchers propose to forecast stock returns by business cycle variables at cyclical frequencies. Yet, there is a fine documentation on the effects of monetary policy and macroeconomic news statement on prices of stock, interest rates and exchange rates. The procedure of monetary policy is used all over the world to achieve desired objectives following the strength and growth of the monetary system of a country and allows the procedure to respond in conditions related to economic growth and inflation. On the darker side, the monetary policy affects are not completely understandable by the policy makers and the academics itself. Various researches on monetary policy had focused on real sector's impact (see Romer and Romer 1989 and Bernanke and Blinder 1992). There is enough proof that bond returns and stocks are predictable. So, the result generated on the monthly basis data is that expected part of returns, or regular, deviations between time of likely returns, is the tiny proportion of return variance. Hence, several researches kept the focus on the bond returns and stock forecasting by utilizing the financial and economic factors. Schwert (1990), Fama (1990) and Fama and French (1988, 1989) found that major variations over likely bond and stock returns can be clarified by term spread, dividend yield and default soread. The expected returns that the investors require differ in excess of the business cycle in light of these studies. Monetary policy affects stock returns according to Johnson and Jensen (1995). Over the period 1962-1991, they found that during expansive monetary policy periods the expected stock returns are considerably high than restricted ones which recommend that monetary rigidity influence on investors' expected returns. This research matches with French and Fama's (1989) point of view that "predictable variation in returns reflects rational variation in required returns".

Impact of expansive Vs restrictive monetary policy:

For many years a country and their government financial sector's vast area of interest has always been the Monetary policy and has huge effects over the country's economy. Either expansionary (increase in supply of currency) or restrictive (decrease in supply of currency), monetary policy has a direct impact on the interest rate. The learning develops a vast and definite measure of fiscal conditions based on Federal Reserve discount rate changes. The practice of a simple binary classification scheme that is based upon the direction of the latest discount rate change is being used. The Federal Reserve purse expansive monetary policy if there was a decrease in the previous discount rate. The Federal Reserve pursue restrictive monetary policy If there was an increase in previous discount rate, as discussed in Hamburger and Kochin (1972) that "chA°nges in the growth rate of money have an immediate negative effect on short term interest rates". Bernanke and Kuttner (2005) revealed that the astonish change in US monetary policy is statistically important with a negative sign, i.e., US stock returns have a negative effect because of a surprising change in the US federal funds rate target. Hence the price of the securities (i.e. equity, bond etc.) are affected because of the change in interest rate. According to Kein and Stambaugh (1986) "the short-term interest rates are accurate and useful predictors of subsequent, realized excess equity returns". Monetary policy affects stock returns according to Johnson and Jensen (1995). Over the period 1962-1991, they found that during expansive monetary policy periods the expected stock returns are considerably high than restricted ones which recommend that monetary rigidity influence on investors' expected returns. This research matches with French and Fama's (1989) point of view that "predictable variation in returns reflects rational variation in required returns".

Impact of monetary policy on portfolio returns:

Another study was carried by Devereux and Sutherland (2007) which depicts the Monetary policy effect on national bonds and equity portfolios by evaluating two countries open economic model in which one was the home country and the other was a foreign country by using a totally different approach. The idea being used was "utility maximization and consumption-leisure trade-off function to estimate home price index and, in turn, gross return on home nominal bond and home equity [2] , and determine interest rate as a function of historic PPI (Producer Price Index) inflation rates". Firstly, the equilibrium was calculated between portfolio under complete market (nominal bonds and equities are traded across countries) and incomplete market (only nominal bonds are traded). Secondly, they analysed the impact on portfolio choice by monetary policy monetary. They analysis lead to the fact that increase in home country's nominal interest rate is caused by home money shock with repercussions of collision between the foreign inflation and domestic inflation relatively, which therefore increases the exchange rate relative to a foreign one and increase in returns on home currency bonds as well. Hence, the significance of equity and bond in the portfolio choice instead of bonds as previously i.e. equity and bonds completely evade all the money shocks possible leads me to use this study for my project. There were same results provided by James Booth and Lena Booth (1997) during their study while they observe the bond returns and expected stock impact by monetary policy while using Federal fund rate and index relied on discount rate change as a measure of monetary policy stance. The restrictive monetary policy results in decrease of return of small stocks so as large socks and in various cases corporate bonds and these results were derived by studying and examining the returns on stock based on S&P 500, and bond, based on Salomon Brothers Long Term High Grade Corporate Bond Index, over the period 1955 through 1992 and by using monthly and quarterly regressions.

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