Why understanding monetary policy is vital to your investment

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Monetary policy

Monetary policy and fiscal policy are two important pillars that provide direction for a country’s economic development and financial management. Economic development is formed by a nation’s central bank. Financial management is formed by the government.

Monetary Policy Stance

The focus of monetary policy is to change the money supply in a financial system according to emergent conditions. It can be expansionary or contractionary. One of the main tools that a central bank uses to change money supply is changing the key rate. For the US, it’s the federal funds rate. For India, it’s the repo rate. Other measures that a central bank can take include conducting open market operations and changing reserve requirements.

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Policy stance

An expansionary policy infuses money into the financial system. A contractionary policy takes money out of the financial system. One way that a central bank can increase money flow is by reducing its key rate. It reduces its key rate when economic growth slows and people are unwilling or unable to spend.

This action helps stimulate economic growth. Taking a cue from the central bank, commercial banks lower their rates. It deters savings because money will earn less than before. However, a rate reduction also lowers rates on loans. This encourages people to buy goods. This increases spending.

Contractionary monetary policy is the reverse of the above. The central bank raises its rates to control inflation. By raising rates, people are encouraged to save money. They’re deterred from taking loans due to the higher rates.

Moves in interest rates are harder than the theoretical framework would make you believe. Moves in interest rates have a wide impact. As a result, you need to watch for a central bank’s policy meetings and announcements.

In India’s case, exchange-traded funds (or ETFs)—like the WisdomTree India Earnings Fund (EPI), the PowerShares India Portfolio (PIN), the iShares MSCI India ETF (INDA), the iShares S&P India Nifty 50 Index Fund (INDY), and the VanEck Vectors India Small-Cap Index ETF (SCIF)—will likely be impacted by the Reserve Bank of India’s (or RBI) policy announcements.

In the next part of this series, we’ll discuss how the policy announcement impacts US Treasuries.

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