In this paper, we examine the relationship between monetary policy and stock market liquidity in a pure order-driven emerging stock market such as India. In addition, we explore the possible asymmetries in the effects of monetary policy on stock market liquidity in different market regimes i.e., optimistic (high sentiment) versus pessimistic (low sentiment) market environment.
To examine the relationship at aggregate market level, in this study we use a multivariate vector autoregressive (VAR) model, carry out a VAR-Granger causality test, impulse response analysis, and variance decomposition tests. The relationship at individual stock level has been analysed using panel fixed-effects model. Empirical estimates reveal that an expansionary monetary policy (lower interest rate or higher money supply) enhances stock market liquidity and a large percentage of information pertinent to liquidity is attributed to monetary policy. Consistent with aggregate market liquidity, the panel estimation results suggest that an expansionary monetary policy significantly leads to an increase in the individual stock liquidity. Further, we find that the relationship between monetary policy and stock market liquidity is stronger during low sentiment periods as compared to high sentiment periods.
This study contributes to and extends the related literature in two aspects. First, the present study is perhaps one of the early studies in the context of an emerging market such as India to examine the impact of monetary policy on stock market liquidity at an aggregate market level, and at firm level using data for individual stocks. Second, this paper is perhaps the first to suggest a possible asymmetric effect of investor sentiment on monetary policy--stock market liquidity relationship. The results are relevant for practitioners and policy makers. From the practitioners’ perspective the empirical findings underline that while monetary policy is important in forecasting stock market liquidity, it is also important to consider the role of investor sentiment. Regulators and policy makers may consider the relationship between market liquidity and monetary policy as an important source of information for policy formulation and implementation.
