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Impact of Monetary Policy on Equity Markets

Monetary Policy

As we know, Equity markets are influenced by a lot of factors such as economic, political & much more & monetary policy is one such factor that affects the stock market. It has an impact on markets as it effectively controls interest rates and liquidity in the financial system. To comprehend RBI's monetary policy and its impact on the stock market, you must first comprehend what RBI is and what it does. So to put in another way, Every family has a family head who is in charge of all other family members and makes important decisions in order to keep the family disciplined and prosperous. The same situation can be observed in banks. The Reserve Bank of India, or RBI, is in charge of all banks in India. It supervises all Indian banks and makes key decisions to ensure the smooth operation of the financial system.

As a result, the Reserve Bank of India serves as the banker to all Indian banks and the government. In a nutshell, it is India's central bank. We can save and lend money to banks based on our needs. Similarly, all banks can borrow and save money from the RBI. In the event of a financial emergency, the Government of India can also seek assistance from the RBI. To dig a little deeper let us understand the role of RBI in monetary policy -

So basically, Monetary policy is how the RBI manages and controls the money supply. The policy's goal is to achieve price stability as well as economic growth. It can be implemented using a variety of instruments or tools. The policy helps to maintain economic stability by adjusting bank rates, buying and selling government bonds, and other measures. Also, The Monetary Policy Committee (MPC) is required by the RBI Act to meet at least four times per year. MPC can meet more than four times, but not less, depending on the urgency. Following each meeting, the MPC must publish its decision.

Types of Monetary Policy by RBI

The Reserve Bank of India (RBI) implements a variety of policies based on market demand. Two common types are Contractionary monetary policy and Expansionary monetary policy -

a) Contractionary Monetary Policy - As the name implies, this type of monetary policy involves contracting or decreasing the money supply in order to combat inflation. Bank interest rates are raised, bank reserve rates are raised, government bonds are sold, and money flow is restricted. Essentially, RBI's policy reduces the money supply and slows the economy in order to combat inflation.

b) Expansionary Monetary Policy - The goal of monetary policy is to achieve the exact opposite of contractionary monetary policy. The Reserve Bank of India (RBI) implements a policy to boost economic growth by increasing the money supply. Lowering interest rates, increasing cash flow, and reducing bank reserves are all part of the policy. It basically serves as a source of energy for the economy as a whole. With this monetary policy, market liquidity is increased.

Instruments for Monetary Policy by RBI

Let us now have a look at the list of important direct and indirect monetary policy instruments - 

a) Liquidity Adjustment facility (LAF)  - The LAF is an extremely important monetary policy tool. Banks can borrow money from the RBI at a fixed interest rate and through repurchase agreements using this instrument. A repurchase agreement allows banks to borrow money from the RBI in exchange for a promise to repurchase it. LAF is made up of two rates: repo and reserve repo.

1) Repo Rate & Reverse Repo Rate - The repo rate is a fixed interest rate at which banks can borrow money from the RBI overnight in exchange for government securities through a repurchase agreement.  The repo rate is changed by the RBI to keep the economy stable. Unlike the repo rate, the reserve repo rate is used by the RBI to borrow money from banks. It also occurs with government-approved securities. This is done by the RBI to absorb excess liquidity in the economy.

The stock market can be affected significantly by changes in the repo rate. If the RBI lowers the repo rate, it will be a huge relief for banks and other interest-rate-sensitive industries. Lower repo rates may benefit investors with positions in the banking sector. Consider a scenario in which the market's inflation rate is much higher. As a result, the RBI will try to slow the economy by raising repo rates. Commercial banks may face difficulties as a result of this. As a result, banking investors would be in a bad situation.

b) Marginal Standing facility (MSF) - Commercial banks can borrow money from RBI overnight by using the MSF facility. The main difference between MSF and LAF is that MSF is available for the long term and is only available to scheduled commercial banks. Banks can borrow money by using their SLR (Statutory Liquidity Ratio) up to a  limit at a certain interest rate.

c) Statutory Liquidity Ratio (SLR)  - Commercial banks are required to keep a certain percentage of their NDTL (Net Demand and Time Liabilities) in the form of gold, cash, or government securities. The SLR rate can be raised by the RBI to limit the money supply in the economy and vice versa.

d) Cash Reserve Ratio (CRR)  - This is the daily balance that banks must keep with the RBI. Commercial banks maintain a shared percent of NDTL in their balances.

The CRR rate can also be changed by the RBI to control liquidity flow. To help commercial banks overcome liquidity constraints, the central bank can reduce the CRR, or cash reserve ratio. This increases the market's liquidity. As a result, investors become more interested in investing in the stock market, and the market rises. For short- and mid-term investors, more liquidity is always a plus. Reduced CRR rates, on the other hand, can demotivate traders and investors. In this case, they are eager to withdraw their funds from the market, and the price falls. Banks, capital goods, the auto sector, infrastructure, real estate, and other sectors may be influenced by CRR movement.

e) Open Market Operations (OMO) - RBI buys and sells short-term and long-term government securities in the open market using this OMO instrument. RBI buys securities to inject liquidity into the market and sells securities to squeeze liquidity. 

f) Bank Rate - RBI approves collateral-free loans to other banks at this bank rate. RBI also buys or rediscounts exchange bills and other government commercial papers at this rate. Furthermore, the bank rate is proportional to the MSF rate. MSF and Bank rate changes always occur at the same time.

Objectives of the Monetary Policy

a) Inflation Rate - A healthy economy necessitates some inflation. Inflation can be controlled through monetary policy. A contractionary policy is best for high inflation, while an expansionary policy is best for deflation.

b) Employment Rate - For the RBI policy, the employment rate and unemployment rate may fluctuate. For example, an expansionary policy raises the employment rate, whereas a contractionary policy raises unemployment. For example, an expansionary policy raises the employment rate, whereas a contractionary policy raises unemployment.

c) Foreign Exchange Rate - Exchange rates between foreign and domestic currencies can be regulated or controlled by policy. RBI can lower the foreign currency value by increasing the money supply.

Lastly to sum this up, Monetary policy has a significant impact on the economy so it is important to comprehend its relevance.

- Team IFA