The Effects of Monetary Policy on Stock Market Performance: A Cross-Country Analysis

Abstract

The study seeks to examine the effects of monetary policy on stock market performance and to know whether monetary policies in various countries affect their own stock market performance and development. The study employed vector error correction model (VECM) on data of the following countries: Australia and New Zealand representing Australia; India and Indonesia representing Asia; Nigeria and South Africa representing Africa; Chile and Trinidad and Tobago representing South America and Jamaica and the United States representing North America. The study used data from 1988 to 2008.

The study found out that monetary policy variables such as money and quasi money growth and interest rates proxied by lending rate as well as intermediate target of monetary policy inflation rate measured at consumer price index have long run relationship with stock market performance measured by growth of market capitalization. This was observed using unit root tests to test for the stationarity of the data as well as cointegration analysis to test for long run equilibrium relationship between the variables.

Furthermore, the study employed vector error correction model (VECM) and generated the impulse-response function and graph for each country as well as their forecast error variance decomposition. The result of our analysis is that although monetary policy has long run relationship with stock markets, this relationship is different in various countries thus rendering the notion of ‘one rule fits all’ invalid. Variations in market capitalization growth in the long run were caused mainly by its own shocks and shocks from money and quasi money growth as was the case in nine countries studied. The last country was explained by lending rate while inflation rate not the major factor in any of the countries.

The study concluded by giving policy recommendations to policymakers to understand the peculiarities of their own markets when formulating and implementing monetary policy.

Keywords: Monetary policy, Stock Markets, Market Capitalization, Interest Rate, Inflation Rate