X

Sign up for Equitymaster's free daily newsletter, The 5 Minute WrapUp and get access to our latest Multibagger guide (2017 Edition) on picking money-making stocks.

This is an entirely free service. No payments are to be made.


Download Now Subscribe to our free daily e-letter, The 5 Minute WrapUp and get this complimentary report.
We hate spam as much as you do. Check out our Privacy Policy and Terms Of Use.
Money supply and bourses - Views on News from Equitymaster
 
 
  • PRINT
  • E-MAIL
  • FEEDBACK
  • A  A  A
  • Aug 19, 2002

    Money supply and bourses

    Businesses are prone to the forces of the economy and business cycles are unavoidable. However, as our understanding of economics improves the severity of business cycles has been reduced by taking steps to counter the downturn in the economy. Of the many steps taken the one that is of the most interest to the stock markets is the change in monetary policy. In this article we look at the impact of the change in money supply (as a proxy for change in monetary policy) on the stock markets.

    But first a few basics.

    The central bank’s job in a country is to ensure the stability of the currency and ensure the right kind of an environment for economic growth. For example, the Reserve Bank of India’s objective is:

    "…to regulate the issue of Bank Notes and keeping of reserves with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage."
    Source: RBI website

    The Federal Reserve Bank’s (central bank in the US) objectives are to facilitate economic growth in line with the economy’s growth potential, ensure a high level of employment, stable prices and moderate long-term interest rates.

    Households keep their saving with a bank and this money is made available to the industry through a banking system of a country, with the central bank at the helm. Thus, the banks act as financial intermediaries. A part of the money that is deposited has to be kept as a reserve with the central bank, RBI in India’s case. The remaining part is given out as loans or is parked in other financial instruments.

    The central bank using the reserves as input prints currency notes i.e. supplies money. The process of creation of money using the deposits is known as multiple expansion of bank deposits. Suppose an investor deposits Rs 100 in a savings account. Of this Rs 10 (10%) has to be kept as reserve with the central bank and the remaining Rs 90 can be given out as loans. The bank loans the amount to a company wanting to start an industrial venture. The company receiving the loan puts the money into another bank account. The second bank has to keep Rs 9 as reserve and give out Rs 91. This process continues. Thus, we find that at a reserve requirement of 10% every rupee deposited can support demand deposits of Rs 10. The ratio of the new deposit to the increase in reserve is known as the money supply multiplier. The central banks print currency accordingly. If a deposit creates money, withdrawal of deposits has the reverse effect that is to remove money from the system.

    The central banks control the flow of money in the financial system through the monetary policy. The tools used for implementing the monetary policy are:

    • Open market operations
    • Interest rates
    • Reserve ratio

    The higher the reserve ratio, higher amount of money, the commercial banks will have to hold with the central bank and thus, the money available to the industry will be lower. Also, the central bank buys and sells government securities (G-secs), which is known as the open market operations. If the central bank sells G-secs, deposits will be withdrawn from the banking system to buy these instruments and this will in turn reduce the liquidity. On the other hand, if it buys back G-secs, it will increase the liquidity in the system. Finally the banks borrow from the central bank when they face shortage of reserves. By altering the rate at which the central banks lends out the liquidity in the systems can be controlled.

    If banks can borrow at lower rates then they can lend out to industries at lower rates also. Thus, the cost of capital becomes cheaper. Depending on the economic environment central banks follow tight money or cheap money policy. When the economy is growing a multiplier effect comes into play. Expectations of future growth propel investments, which in turn drive employment and higher employment results into increased spending. However, increased spending could cause the risk of inflation. Thus, by limiting the availability of money or making it dearer, the central bank steers the economy away from inflation.

    In 1979, when the US economy had high levels of inflation the Federal Reserve under the chairmanship of Paul Volcker undertook the monetarist experiment. It reigned in the growth in bank deposits and reserves. Consequently, the inflation declined sharply between 1979 and 1982. The slow money growth caused interest rates to soar. This impacted investments adversely and the economy stagnated. The unemployment rose from about 6% to about 10% in 1982. On the other hand, to counter the slowdown in the US economy the Fed has reduced rates from 6.5% beginning January 2001 to 1.75% on December 2001.

    Thus, the central bank of a country tries to counter the weak economy by reducing the cost of one of the most important inputs for business - money. By effectively increasing the money supply into a country’s financial system, the availability of capital is made cheaper with the hope that investments in business becomes more lucrative and investments begin to take place.

    Lower interest rates are good for the stock markets. This is due to the fact that lower interest rates make the other asset classes that compete with equities like fixed deposits become relatively less attractive. Also, lower interest rates mean that the interest burden on corporates that have a raised a significant part of their capital through debt reduces. Consequently, earnings tend to grow at a faster pace and therefore, stock markets are again benefited in the long run.

    Thus, growth in money supply should result to better performance for the stock markets. While there seems to be not much of a correlation, the stock market indices seem to mirror the growth in money supply with a lag effect. Higher growth rates have been followed by stock market indices gaining significantly in subsequent years. However, more prominent is the fact that a lower growth rate in money supply has caused index to decline more often than not. This has been seen for both the Indian the US markets. It is very difficult to come to a definite conclusion especially for the Indian markets since scams distort the data significantly. Also, stock markets are not purely driven by fundamentals.

    Since October 2001 the RBI cut the cash reserve ratio by 2.5% to 5%. Further the bank rate has also been lowered by 0.5% to 6.5%. This effectively means more than Rs 80 bn has been added in the system. But this has not been reflected by the stock markets. Of course bond markets have rallied since, indicating that part of the money has found its way into debt. It leaves us to wonder how long before the money comes into equities.

     

     

    Equitymaster requests your view! Post a comment on "Money supply and bourses". Click here!

      
     

    More Views on News

    How to Ride Alongside India's Best Fund Managers (The 5 Minute Wrapup)

    Jun 10, 2017

    Forty Indian investing gurus, as worthy of imitation as the legendary Peter Lynch, can help you get rich in the stock market.

    Will They Haul Off Trump's Statue, Too? (Vivek Kaul's Diary)

    Aug 16, 2017

    All across the country, the old gods become devils. New, gluten-free gods take their places...

    This Company Beat the Business World's 'Three Killer Cs' (The 5 Minute Wrapup)

    Aug 16, 2017

    And what it has in common with beating the stock market too.

    5 Steps To Become Financially Independent (Outside View)

    Aug 16, 2017

    Ensure your financial Independence, and pledge to start the journey towards financial freedom today!

    Let's Hope This Correction Continues (The 5 Minute Wrapup)

    Aug 14, 2017

    Last week's correction is making a number of Super Investor stocks look a lot more attractive...

    More Views on News

    Most Popular

    Demonetisation Barely Made Any Difference to Tax Collections(Vivek Kaul's Diary)

    Aug 7, 2017

    The data tells us quite a different story from the one the government is trying to project.

    Proxy Plays: A Smart Way to Bet on 'Off Limits' Companies(The 5 Minute Wrapup)

    Aug 4, 2017

    The small-cap space is full of small players that are clear proxies to great growth stories and Indian megatrends.

    Should You Invest In Bharat-22 ETF? Know Here...(Outside View)

    Aug 8, 2017

    Bharat-22 is one of the most diverse ETFs offered so far by the Government. Know here if you should invest...

    Signs of Life in the India VIX(Daily Profit Hunter)

    Aug 12, 2017

    The India VIX is up 36% in the last week. Fear has gone up but is still low by historical standards.

    7 Financial Gifts For Your Sister This Raksha Bandhan(Outside View)

    Aug 7, 2017

    Raksha Bandhan signifies the brother-sister bond. Here are 7 thoughtful financial gifts for sisters...

    More
    Copyright © Equitymaster Agora Research Private Limited. All rights reserved.
    Any act of copying, reproducing or distributing this newsletter whether wholly or in part, for any purpose without the permission of Equitymaster is strictly prohibited and shall be deemed to be copyright infringement.

    LEGAL DISCLAIMER: Equitymaster Agora Research Private Limited (hereinafter referred as 'Equitymaster') is an independent equity research Company. Equitymaster is not an Investment Adviser. Information herein should be regarded as a resource only and should be used at one's own risk. This is not an offer to sell or solicitation to buy any securities and Equitymaster will not be liable for any losses incurred or investment(s) made or decisions taken/or not taken based on the information provided herein. Information contained herein does not constitute investment advice or a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual subscribers. Before acting on any recommendation, subscribers should consider whether it is suitable for their particular circumstances and, if necessary, seek an independent professional advice. This is not directed for access or use by anyone in a country, especially, USA or Canada, where such use or access is unlawful or which may subject Equitymaster or its affiliates to any registration or licensing requirement. All content and information is provided on an 'As Is' basis by Equitymaster. Information herein is believed to be reliable but Equitymaster does not warrant its completeness or accuracy and expressly disclaims all warranties and conditions of any kind, whether express or implied. Equitymaster may hold shares in the company/ies discussed herein. As a condition to accessing Equitymaster content and website, you agree to our Terms and Conditions of Use, available here. The performance data quoted represents past performance and does not guarantee future results.

    SEBI (Research Analysts) Regulations 2014, Registration No. INH000000537.

    Equitymaster Agora Research Private Limited. 103, Regent Chambers, Above Status Restaurant, Nariman Point, Mumbai - 400 021. India.
    Telephone: +91-22-61434055. Fax: +91-22-22028550. Email: info@equitymaster.com. Website: www.equitymaster.com. CIN:U74999MH2007PTC175407
     

    Become A Smarter Investor In
    Just 5 Minutes

    Multibagger Stocks Guide 2017
    Get our special report, Multibagger Stocks Guide (2017 Edition) Now!
    We will never sell or rent your email id.
    Please read our Terms

    S&P BSE SENSEX


    Aug 16, 2017 (Close)

    MARKET STATS