International Journal of Management and Economics Fundamental
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VOLUME
Vol.05 Issue01 2025
PAGE NO.
5-12
10.37547/ijmef/Volume05Issue01-02
The Impact of Monetary Policy on Financial Markets
Dhuha Dhulfiqar Ali AL-Obaidi
Collage of Administration and Economics, University of Babylon, Iraq
Received:
19 October 2024;
Accepted:
22 December 2024;
Published:
06 January 2025
Abstract:
This research addresses the interrelationship between financial markets and monetary policy, reviewing
the impact of fluctuations in financial markets on the economic decisions taken by central banks. Financial markets
are considered one of the most important tools through which monetary policies can be transmitted to the
economy, as fluctuations in stocks, bonds and interest rates affect investment and savings decisions. The research
shows how these fluctuations affect inflation rates and economic growth, highlighting central banks' crucial role
in controlling liquidity and preventing financial crises. It also discusses how monetary tools such as interest rates
and open market operations achieve economic stability. The research highlights that financial markets can act as
a channel for transmitting monetary policy. Still, at the same time, they may complicate the economic decision-
making process due to unexpected fluctuations. There is also a strong interaction between financial markets and
monetary policy, which requires integrated strategies to achieve macroeconomic stability.
Keywords:
Financial markets, macroeconomic stability, monetary policy.
Introduction:
There is no doubt that monetary policies
have an influential role in establishing frameworks that
support sustainable economic growth because the
primary goal of this policy, according to what is called
the Kaldor square, is to achieve monetary stability,
balance
of
payments,
acceptance
of
low
unemployment rates, and support for investment
activity through lending policies, as it represents the
main engine of the wheel of economic activity.
The financial market is a good space for applying
monetary policy, especially when using indirect
quantitative tools. These tools facilitate the work of the
monetary authority in its attempt to control changes in
the money supply and then the value of money. In this
direction, the financial market works to create the
necessary liquidity to facilitate economic growth and
increase rates.
First: The importance of the study: Study Importance
The conditions of the financial market, which mirror the
general economic situation, and the stability of these
markets measure the success of economic policies,
including monetary policy. Some aspects of these
policies can also be modified or changed in a manner
consistent with the stability of the financial market.
Problem of the Study
The study's problem is to examine the extent to which
the financial market is affected by the monetary
variables left by monetary policy.
Study Hypothesis
The study is based on a hypothesis that (monetary
policies impact the financial market's performance, and
the degree of this policy and its variables vary according
to the level of economic activity in that country).
A The approach of the Study
The study adopted the inductive approach to reach the
validity or falsity of the general hypothesis that we
adopted,
Objectives of the Study
The study aims to understand the theoretical aspects of
the financial market and monetary policy and the
relationship between economic policy and the financial
market.
Structure of the Study
The study was divided into three sections. The first
requirement dealt with the theoretical framework of
the financial market, while the second requirement
dealt with the theoretical framework of monetary
policy. The third requirement came with the impact of
monetary policy on the financial market, and the study
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International Journal of Management and Economics Fundamental (ISSN: 2771-2257)
concluded with a set of results and recommendations.
The first requirement: The theoretical and conceptual
framework of the financial market
First: (The nature of the financial market)
1 - The concept of the financial market: The concept of
the financial market differs according to the basic
function it performs and the institutions that make up
this market, and its mechanism is summarized in
(transferring balances prepared for lending from units
with a financial surplus to units with a financial deficit,
i.e. transferring balances that can be loaned) (1).
Based on the above, financial markets can be defined
as:
- The market in which different parties, individuals and
institutions, deal in buying and selling securities
consisting of stocks and bonds, and they may be
organized or unorganized. The organized market is
where the buying and selling of securities transactions
takes place in a specific geographical location called
(the stock exchange), while the unorganized market
consists of traders and brokers who conduct their
business and communicate with each other through
means of communication. In this regard, stocks
represent ownership certificates and bonds represent
loan certificates.
- A regulatory framework under which securities are
traded through which flows are financed.
2- The emergence of stock markets (2)
The origin of the stock exchange or stock market dates
back to the late thirteenth century AD in the city of
(Bruges) in Belgium, when the owners of trading and
exchange houses who moved to it from Italy settled
there and established their colonies there, and it
became a place for merchants and businessmen to
gather. In 1300 AD, the stock exchange of this city was
established and continued to occupy the leading
financial and commercial position among cities until
1485 AD, when the (Anvers) stock exchange was
established in the city of (Antorp) and the name (stock
exchange) goes back to the name of the (Vander
Buerse) family until the exchange movement
developed to take the name of this family. There are
those who attribute the word stock exchange to the
French language, which means (money bag), as its
origin goes back to a hotel in the Belgian city of Bruges,
whose facade was decorated with a picture of a logo
consisting of three money bags where money changers
and merchants met. The process of forming stock
markets known as stock exchanges went through a
development phase in the sixteenth and seventeenth
centuries to become organized markets for the
movement and trading of capital. The first stock
exchange was in France in 1724, in Britain at the
beginning of the nineteenth century, and in America in
1821 on Wall Street.
In general, the stages that stock markets went through
until they reached what they are now can be listed:
1 - The emergence of commodity exchanges: They are
the oldest types of stock exchanges. A commodity
exchange emerged in Paris around 1304, followed by a
stock exchange in Amsterdam in 1608 AD, as they were
markets for future sales. 2- Trading some securities: It
began in France when some securities such as bills of
exchange were traded during the thirteenth century
AD, and the trading process was organized by creating
the profession of brokerage in exchange, which was
created by King Philip the Blond, and a type of dealing
in credit bonds was unified in England in 1688, and the
East India Company traded shares.
3- Separation of trading in securities from the
commodity exchange: Here, the traders dealing in
securities went outside the commodity exchange to its
edges in the approaches and nearby cafes where
trading takes place outside the commodity exchange.
4- The emergence of stock exchanges: This stage
coincided with the industrial revolution and the start of
work on large projects that individuals cannot finance,
and with industrial expansion, rising income levels,
broad economic growth and the expansion of trading in
securities, all these factors encouraged the emergence
of organized securities markets with advanced
methods of dealing, which became independent in
their structures and systems.
The oldest financial markets in the world are the
London, Paris, New York and Tokyo Stock Exchanges.
-Development of financial markets (1)
A quick look at the stages that the development of
financial markets went through with all their
implications of monetary and capital markets until they
became this widespread form, as follows:
A- The first stage: This stage prevailed in the presence
of a large number of private commercial banks, in
addition to banking operations and individuals'
orientation towards investing in projects due to their
savings.
B- The second stage: In which the spread of central
banks in the world began and their organization of the
work of commercial banks in countries.
C- The third stage: The emergence of specialized banks
such as agricultural, industrial and real estate banks,
which work to grant medium- and long-term loans and
issue long- and medium-term bonds to cover the
shortage of funds in financing various projects.
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International Journal of Management and Economics Fundamental (ISSN: 2771-2257)
D- The fourth stage: The expansion of monetary
markets in countries and the expansion in the issuance
of short-term government bonds (treasury bills) in
addition to medium- and long-term ones and the
spread of the issuance of securities and certificates of
deposit and the integration of expansion in secondary
markets and advanced monetary markets.
E- Financial globalization and the integration of local
financial markets with global ones and international
financial markets and the development of the local
banking system and its connection to the global system
and the high mobility and large flows of money
between countries with ease and speed.
Second (Development of financial markets and their
role in economic activity)
1- Factors that helped the emergence and
development of financial markets (1)
Many factors helped the emergence and development
of financial and monetary markets and increased their
importance, we mention their essence as follows:
A- The availability of a greater amount of national and
individual incomes, which allowed a greater amount of
savings as a result of the state of development in
developed countries, and as a result of the tangible
increase in incomes in developing countries, despite
their relative and limited development, and this
ultimately led to a greater need to use these savings
that were achieved to a greater extent in order to
achieve a corresponding return, and this is done by
using them in financial and monetary markets.
B- The limited areas of use of financial resources,
whether in developed or developing countries, despite
the difference in the reasons for this limitation, which
necessitated the search for additional areas for the use
of these financial resources in the financial and
monetary markets, because developed countries have
a large, diverse and wide range of productive projects
and infrastructure facilities (roads, transportation,
electricity, water, etc.), and therefore they do not need
a large amount of financial resources for use in these
areas, and for this reason there is a surplus of money
that exceeds its need, and this surplus is directed
towards developing countries through financial
markets, while the limited use of financial resources in
developing countries, despite their urgent need for
such resources, is linked to their weak ability to use
them in the broad areas they need, whether in
financing the establishment of productive projects or
infrastructure projects, which leads to the direction of
resources towards non-productive (marginal) areas
and the weakness of their direction towards productive
areas, especially those most important for satisfying
the needs of individuals, or meeting the requirements
of the development process. Therefore, financial and
monetary markets can provide an alternative to use
instead of using them in unproductive and unnecessary
areas.
C- The large and huge sizes of projects at the present
time, especially the contribution of them, which is
usually accompanied by the wide use of advanced
technology with capital intensity, are all factors that
lead to the need for such projects for huge financial
resources, some of which depend on the financial
resources available in the financial and monetary
markets, and thus this matter contributes to expanding
the work of these markets and their development.
D- Increasing the number of intermediary financial
institutions, and increasing the degree of their diversity
and sizes, which undertake the task of mediation
between savers and investors, and the huge financial
resources available to them contribute to expanding
the work of the financial and monetary markets
through their huge transactions in these markets
through buying and selling operations (demand and
supply), which includes expanding the supply and
demand of papers in the financial and monetary
markets in a way that helps to develop these markets
to a tangible degree. E - The development of the means,
tools and services provided by these markets in a
manner that is increasing and diversifying to a large
extent and continuously, so that these markets provide
savers with many areas to use their savings by investing
their savings in them, which encourages dealing in
these markets and thus contributes to expanding this
dealing and thus developing their work.
F - The interconnectedness of the economies of the
countries of the world in general, and the increase in
economic relations between them, among which and
perhaps the most important in bringing about
development in the work of financial and monetary
markets is what is related to liberalizing the movement
of capital and its transfer between countries by
canceling the restrictions that limit this movement and
in a way that contributes to extensive dealings in the
markets from outside the borders of the countries in
which these markets exist, so that these dealings are
added to the local dealings in them in a way that leads
to bringing about significant development in the work
of financial and monetary markets as a result,
especially within the framework of the trends towards
globalization and liberalization of the economy, which
have increased clearly in recent years.
Y - Concentration and internationalization ( ) of the
activity of financial institutions, such that it has become
possible for them to obtain huge, even very huge,
financial resources through concentration resulting
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from the expansion and development of their
operations, or as a result of merging some of them with
others. Internationalization has also made it possible
for these financial institutions, and many of them
giants, to obtain resources from many countries and
use them in several countries as a result of
internationalizing their activity, i.e. practicing their
activity in more than one country, whether it is related
to obtaining financial resources or using these financial
resources, such that all of this has led to the availability
of enormous financial capabilities that enable them to
move huge amounts of money between countries and
to deal with them in the financial and monetary
markets in these countries, which has contributed
significantly to the expansion and development of the
work of the financial and monetary markets. 2- The role
of financial markets in economic activity (1)
The stock market represents a link between most of the
influential economic centers such as banks, companies,
savers, investors, etc., which qualifies it to provide a
general indicator of price trends and savings and
investment rates (macroeconomic indicators). It also
contributes to studies that aim to identify fruitful
economic activities and provide opinion and advice to
the relevant authorities to achieve coordination and
integration between investment activities, monetary
and financial policies, and the movement of capital,
which helps in achieving economic stability.
The stock markets promote development by providing
the necessary capital to finance economic projects
through the owners of these projects offering their
shares in the stock market, which represent entities
with a financial deficit, in order to obtain the necessary
financing from entities with financial surpluses. And
obtaining an efficient allocation of capital for
productive investments at a relatively lower cost.
The financial markets contribute to helping increase
production levels and raise the level of employment or
employment, and thus achieve better levels of income
at the individual and national levels.
The government can also implement its economic
policy, especially monetary policy, through the stock
market, by using monetary policy tools, specifically the
open market tool for buying and selling securities.
Therefore, financial markets are the main engine for
driving economic growth, due to their great importance
in converting negative savings into positive savings that
benefit the local economy and the capital owner alike,
as financial markets have the ability to force hoarders
to transfer their frozen money to the investment
market, in addition to the fact that stock profits will
encourage individuals to abandon some inherited
consumer habits in exchange for obtaining additional
profits on their money.
These markets work to achieve an effective balance
between the forces of supply and demand for money
and allow complete freedom to conduct all exchanges
between dealers, as the importance of this market
increases in countries characterized by economic
freedom and where the economy depends on
individual and collective initiative.
Second requirement
The conceptual and theoretical framework of monetary
policy
First: Monetary policy (concept, objectives, tools)
1. The concept of monetary policy (monetary policy
concept)
1- They are the procedures and measures followed by
the central bank to influence the supply of money,
credit and the exchange rate in order to achieve the
goal of monetary stability in the country.
2- They are the contractionary or expansionary policies
carried out by the monetary authority to influence
economic activity by influencing the volume of credit
and money supply using open market policies and
changing the rediscount rate and changing interest
rates on loans.
2- Monetary policy objectives (3): (monetary policy
coals) Monetary policy aims within the framework of
macroeconomic policy to achieve the desired overall
objectives called the Kaldor square (magic square),
which are increasing GDP growth rates, reducing
unemployment rates, achieving balance in the balance
of payments, and achieving stability in the general price
level. These objectives vary between developing and
developed countries (*) due to the difference in growth
rates and institutional differences in them, and the
objectives associated with each stage, as the nature of
the stage plays a role in achieving these objectives. The
following figure represents the Kaldor square (N-
Caldor) for monetary policy objectives.
A- Achieving price stability: (Realization of price
stability)
The goal of stabilizing the general level of prices is a
necessary condition for the smooth running of the
economy. Usually, price fluctuations fundamentally
affect the structure of the existing economic system,
and therefore, rising prices increase the risks of
investment and economic growth. Some attribute the
decline in economic growth in the countries of the
South American continent to the high inflation rates
that these countries suffer from (4). In most cases,
those in charge of monetary policy in developed
countries are interested in the policy of targeting
inflation (Inflation Targets) as an intermediate and
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primary goal to influence other macroeconomic
variables (5). It is worth noting that the importance of
price stability (*) appears in providing a fertile and
suitable economic environment to attract direct
foreign investment (Direct investment) and indirect
investment (indirect investment), which helps
stimulate investment among producers and thus
accumulate capital and increase economic growth (1).
B- Achieving a high level of employment: Realization of
full employment)
This goal is considered one of the most important final
goals for two reasons: First: The increase in
unemployment rates leads to social problems, so
citizens suffer from real financial problems. The second
reason: The low level of employment causes economic
activity to lose its basic production factors, represented
by the unused labor force, which is an influential
productive element in the economy. Treating the
unemployment problem and achieving natural
unemployment rates (Natural rate of Employment) (*),
which usually range between (4.5-6)%, must be in line
with the procedures of the monetary authority to
stimulate economic activity and activate the wheel of
investment, thus increasing the level of employment, in
addition to raising the level of total demand and
maintaining the growth rate of the gross domestic
product in a way that matches the growth rate of the
money supply (2(.
C- Achieving stability in financial markets: Realization
stability of financial market
There is no doubt that the state of instability in financial
markets affects their effectiveness in matching savers
and investors, i.e. a decline in the exploitation of
financial resources due to the difficulty of obtaining the
capital necessary to finance capital investments, and
thus the stability of Financial market institutions and
providing a fertile environment for them makes the
process of transferring capital proceed with high
efficiency (3).
D- Achieving stability in the balance of payments
(Realization of A stable balance of payment
Monetary policy can address the imbalance in the
balance of payments. When a deficit occurs, the
monetary authority raises the rediscount rate, which
contributes to the inflow of short-term capital into the
country, which works to balance the balance of
payments. The other direction comes through changing
internal prices, which will decrease, leading to an
increase in the volume of exports, which leads to the
same result, or the two directions may come together
to remove the deficit from the balance of payments (1).
E- Realization of high rates of economic growth:
Monetary policy, through the control it exercises over
the volume of bank credit and its cost, increases
economic growth (*), and the monetary authority can
make changes in the volume of total reserves of local
commercial banks. Expansionary monetary policy can
maintain a low interest rate, which increases demand
for credit and investment and achieves economic
growth (2). Second: Channels of transmission of the
effects of monetary policy to economic activity
1- Interest rate channel: This channel is considered the
most important channel of transmission of the effects
of monetary policy to the real sector, and (Keynes) is
the first to address this channel)4. When the monetary
authority decides to make a change in the money
supply, the first channel that transmits the effect of this
change to economic activity is the interest rate
channel. When assuming a certain flexibility of
investment and a certain marginal adequacy of
invested capital, and when following an expansionary
monetary policy by increasing the money supply, this
will lead to a decrease in the nominal interest rate, and
in light of the assumption of stable prices, the real
interest rate will decrease accordingly (*), which will
lead to a decrease in the cost of capital and an increase
in investment activity and an increase in the pace of
aggregate demand and thus production and use.
2- Exchange price channel: Interest in this channel has
increased with the expansion of global economic
exchange in light of the rising trend towards
internationalization of the economy (*). The role of the
exchange rate channel is highlighted in transmitting the
impact of monetary policy to economic activity through
the value of the local currency and through the interest
rate. Changes in exchange rates are reflected in
changes in aggregate demand and supply. The
monetary authority’s action
to reduce the money
supply will lead to an increase in the real interest rate
within the local economic activity relative to its
counterpart abroad, which results in a movement of
foreign capital flows inward. These flows will increase
the demand for the local currency, leading to an
increase in its real value, which negatively affects the
quantity of exports (it becomes more expensive than
foreign goods) and the country’s current account
position and its reflection on the decline in GDP growth
(1).
3- The asset price channel The impact of monetary
policy is transmitted through this channel through two
channels: the Tobin investment channel and the wealth
effect channel on consumer spending. Through q-Tobin
(*), expansionary monetary policy works to raise stock
prices, which makes investment more attractive and
thus increases aggregate demand. The process of
raising stock prices also necessitates an increase in
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International Journal of Management and Economics Fundamental (ISSN: 2771-2257)
wealth, leading to an increase in consumer spending
and thus increases aggregate demand. Also,
4- Credit channel: The role of this channel is highlighted
through the impact of monetary policy on output and
through rationalizing spending, and it is divided into
two channels, the first: Bank Lending channel, and the
second: Balance sheet channel (3), the first channel
goes to that the decrease in the money supply leads to
a reduction in the size of deposits, which reduces the
ability of banks to provide loans or financing for
projects and companies, as this works to reduce
investments in these companies, especially small ones
that depend mainly and mainly on bank financing, and
thus results in a decrease in the growth rate of output,
and the opposite happens in the case of an increase in
the money supply (4), as for the second channel, it plays
its role through moral risks and negative selection risks,
when following a contractionary monetary policy, the
risks of neglect and poor selection of borrowers
increase, as the decrease in the money supply reduces
the net value of companies, and thus reduces the
guarantees that must be provided by the company
when borrowing, which results in not providing Loans
to these companies, especially small ones, from
financing banks, and thus negatively affect their
investments and cause a decline in the growth of
output (5), and the transfer of the effect can be
represented in the two channels as in the diagram:
Second: Traditional tools of monetary policy (Monetary
policy tools)
A1. Legal reserve ratio: This tool is one of the tools or
means that central banks resort to in order to influence
the ability of commercial banks to grant loans and
create deposits, and the central bank usually resorts to
using it to influence the money supply by imposing a
percentage of the total bank deposits for the purpose
of keeping them as a credit balance in the central bank
as a legal reserve (2)
2- Discount rate: We mean by it the interest that the
central bank obtains from commercial banks in
exchange for these banks discounting the securities it
has in order to obtain the necessary liquidity for the
purpose of granting loans to individuals and companies
(2), and the purpose of this policy is to influence the
granting of credit, as raising the discount rate reduces
the ability of banks to grant credit, while reducing it
sends clear indications of the expansion in granting
Credit, and commercial banks transfer this burden by
raising interest rates on bank loans, which results in an
increase in the cost of credit and thus a contraction in
its volume. However, in the case of economic
recession, the monetary authority resorts to following
an expansionary policy by reducing the discount rate,
which results in commercial banks reducing interest
rates on bank loans, which leads to an expansion in the
volume of credit.
In addition to the above, there are many channels that
the monetary authority can use to influence the
financial market, the most important of which are the
rediscount rate, open market operations, and the legal
reserve ratio. The central bank can influence financial
investments through these channels. The effects of the
monetary authority’s use of the discount rate tool in
the financial market extend through the monetary and
capital market to change the lending provisions to
commercial banks from the central bank, i.e.
influencing the siz
e of commercial banks’ reserves. As
for open market operations, the second tool through
which the impact of monetary policy on market activity
can reach the buying and selling of short-, medium-,
and long-term government securities and through
influencing the price and interest rate channel, in
addition to the cash reserves channel. As for the third
tool (the legal reserve ratio), the central bank can
control that ratio, which prompts commercial banks to
resort to the financial market to display their securities.
Thus, the previously mentioned analysis focuses on
indirect quantitative monetary policy tools because the
direct qualitative tools of monetary policy hinder the
activity of the financial market for several reasons (2).
The effectiveness of monetary policy, especially the
quantitative one, depends on regular financial markets
as the scope of work of these tools changes. Therefore,
these markets must be highly efficient and effective to
implement these tools, i.e. they must have great
capacity and be able to absorb vast quantities of
government bonds offered by the central bank through
open market operations, as well as its ability to
implement the bank rate policy. The impact of the
financial market on the implementation of monetary
policy is as follows: (3)
1- The bank rate is one of the interest rate structures
that must be determined in the financial market,
especially the money market, as deciding the bank rate
depends on changes affecting the supply and demand
sides of liquidity in the money market.
2
—
The effectiveness of the bank rate requires a strong
relationship between it and other interest rates in the
financial market, as changes in the bank rate depend on
changes in interest rates in the market. This requires
the existence of an efficient financial market.
3
—
The existence of a developed (short-term) financial
market in which credit instruments are rediscounted by
the central bank facilitates the implementation of
monetary policy procedures.
4- The success of the open market policy depends on a
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International Journal of Management and Economics Fundamental (ISSN: 2771-2257)
large, active and highly effective bond market, as
previously mentioned. Thus, the development of the
financial market makes monetary policy tools
(quantitative) more effective and influential in all
macroeconomic variables by providing the optimal
scope for their application and extending their impact
towards the intended objectives of their use.
RESULTS
1- Monetary policy is one of the influential factors and
essential channels for transferring financial surpluses in
the financial market.
2- Financial markets have become the proper mirror for
judging the extent of the development of the financial
domain in countries, especially in developing countries.
3-Financial markets are one of the main determinants
of the effectiveness of monetary policy in a country.
4- Open market policies are the most essential tool in
transferring the financial impact of financial markets.
5-Capital markets represent one of the important
channels for accumulating and managing wealth and
are the most important institution that affects the
economy's ups and downs.
Recommendations
1- Since financial markets are part of the economy and
a true mirror of the economy, monetary decision-
makers must evaluate the negatives in their decisions
towards financial market indicators.
2- The necessity of adopting policies for economic and
financial terminology to reflect on the development of
financial markets, which have become a significant
component of the structure of the economies of
developing and developed countries.
3-Establishing active and effective centers within the
financial markets that allow investors and traders to
view all monetary decisions issued by the central bank.
4- Conduct more research on this topic and the Iraq
Stock Exchange to develop scientific results that reflect
the impact of monetary policy on financial market
indicators.
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