The Impact of Monetary and Fiscal Policy on the Stock Market.
Introduction:
The stock market refers to public markets that exist for issuing, buying and selling stocks that trade on a stock exchange. It also refers to the number of markets and exchanges where regular activities of buying, selling, and issuance of shares of publicly-held companies take place. The main role of a stock market is to control and regulate the exchange of stocks, as well as other financial assets. Such regulation ensures a fair environment for not only investors but also the corporations whose stocks are traded in the market.
The idea behind how the stock market works is rather simple. Acting much like an auction house, the stock market facilitates buyers and sellers to bargain prices and make trades. Investors can then buy and sell these stocks among themselves, and the exchange follows the supply and demand of each listed stock.
In today’s article, we shall be taking a look at the effect of fiscal and monetary policy on the stock markets.
Fiscal Policy:
In economics and political science, fiscal policy is how the government uses taxing and spending to expand or contract economic growth or stabilize the economy. The main goals of fiscal policy are to achieve and maintain full employment, reach a high rate of economic growth, and to keep prices and wages stable. But, fiscal policy is also used to curtail inflation, increase aggregate demand and other macroeconomic issues. It is the sister strategy to monetary policy through which a central bank influences a nation’s money supply. There are two main types of fiscal policy: expansionary and contractionary.
Expansionary Fiscal Policy:
Expansionary fiscal policy is a form of fiscal policy that involves decreasing taxes, increasing government expenditures or both, to combat recessionary pressures. The two major examples of expansionary fiscal policy are tax cuts and expanded government spending. Both of these policies are designed to raise aggregate demand while adding to deficits or drawing down of budget surpluses. Expansionary fiscal policy is usually financed by increased government borrowing and selling bonds to the private sector.
While expansionary policies essentially boost the budget deficit or reduce surpluses in the short term, the intention is that by spurring more economic activity, the overall economy will expand, making up for short-term deficits with long-term economic growth. This is because even a moderately constrained boost if intelligently focused on, can have a multiplier effect on the whole economy. The opposite of expansionary fiscal policy is contractionary fiscal policy.
Contractionary Fiscal Policy:
Contractionary fiscal policy is decreased government spending or increased taxation. The contractionary fiscal policy makes the populace less wealthy and decreases output or national income. The goal of contractionary fiscal policy is to close an inflationary gap, restrain the economy, and decrease the inflation rate.
Contractionary fiscal policy decreases the level of aggregate demand by decreasing consumption, decreasing investments, and decreasing government spending, either through cuts in government spending or increases in taxes. Contractionary fiscal policy can lead to a fall in real GDP that is larger than the initial reduction in aggregate spending caused by the policy.
Monetary Policy:
Monetary policy is a central bank’s actions and communications that regulate the money supply and interest rates in an economy to influence output, employment, and prices. Monetary policy can also be said to be an economic policy that manages the size and growth rate of the money supply in an economy. Central banks use three chief instruments in monitoring the money supply: open market operation (omo) the discount rate and reserve requirements. There are two main types of monetary policy: expansionary and contractionary.
Expansionary Monetary Policy:
Monetary policies are actions taken to affect the economy of a country. Expansionary monetary policy is when a central bank uses its tools to stimulate the economy. Expansionary monetary policy involves cutting interest rates or increasing the money supply to boost economic activity. If central banks cut interest rates, it will tend to increase overall demand in the economy.
Interest rate cut makes it cheaper to borrow; this encourages firms to invest and consumers to spend. Also, an interest rate cut reduces the cost of mortgage interest repayments. This gives households greater disposable income and encourages spending. Lower interest rates reduce the incentive to save and above all, reduction in the value of money, making exports cheaper and increase export demand.
Contractionary Monetary Policy:
Contractionary monetary policy is a form of the economic policy used to fight inflation which involves decreasing the money supply to increase the cost of borrowing which in turn decreases GDP and dampens inflation. Contractionary monetary policy causes a decrease in bond prices and an increase in interest rates. Higher interest rates lead to lower levels of capital investment. The higher interest rates make domestic bonds more charming, so the demand for domestic bonds rises and the demand for foreign bonds falls.
Fiscal Policy vs Monetary Policy:
Both fiscal and monetary policy is an endeavor to lessen economic fluctuations and smooth out the economic cycle. The principal distinction is that Monetary policy uses interest rates set by the Central Bank. Fiscal policy involves changing government spending and taxes to regulate the level of aggregate demand.
Impact of Monetary and Fiscal Policy on the Stock Market:
Production in economics is a process of converting diverse material inputs and immaterial inputs into output. Production in the ordinary sense means the creation of a commodity. Firms, particularly manufacturing companies are saddled with the responsibility of converting inputs to an output. These various companies are mostly public limited liability companies i.e. they are companies company that has permission to issue registered securities to the general public through an initial public offering (IPO) and it is traded on at least one stock exchange market.
The stock market refers to public markets that exist for issuing, buying and selling stocks that trade on a stock exchange or over-the-counter (otc). The essence of both monetary and fiscal policy is to regulate the money supply and interest rates in an economy and to maximize economic growth.
In the monetary policy corner, The money supply influences interest rates and inflation, both of which are major determinants of employment, cost of debt and consumption levels. Interest rates affect the operation of companies, either positively or negatively. For example, If the interest rate is increased, production would be affected, because companies’ access to capital for production would be disrupted. I.e. in the area of the firm’s capital generation which is an important factor production would be highly influenced.
A high-interest rate affects consumer’s disposable income, these consumers won’t be able to buy shares and stocks, so also the companies would get loans at a higher rate, depending on the basis point increment in interest rate. Capital is an important factor of production because it’s what allows labor and land to be purchased.
In the fiscal policy corner, if there is an increment in the tax rate, a tax increase will decrease disposable income, because it takes money out of households. These households won’t be able to purchase shares, because savings spurs investment. Production would also be impacted. A rise in corporation tax (on business profits) has the same effect as an increase in costs which can lead to raised prices. The consumer bears this cost.
In conclusion, monetary policies and fiscal policies are needed and essential for economic growth. However, if the right proportion and dosage aren’t injected into the economy, by the custodian of these policies, the stock market amongst other macroeconomic institutions would be affected.
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-WINSALA Gbotemi.
- Staff Writer, Eagle Global Markets.
-First published on egmanalytics.com
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