What Is the Connection between Monetary Policy and Asset Prices?

Government agencies use monetary policy tools to influence productivity, consumer spending and the overall performance of the economy. The connection between monetary policy and asset prices is most obvious during deflationary and inflationary cycles. Some monetary policies cause assets prices to rise while others normally cause prices to drop.

Among other things, government agencies use monetary policy to decide how much currency to print. A national mint can increase the nation’s money supply by simply printing more bills; when this occurs, the value of the national currency decreases because the supply of money begins to outstrip the demand. Prices rise when the value of a particular currency drops, because sellers adjust prices upwards to ensure that the real value of the goods that they sell remains unchanged. Consequently, investors often notice the connection between monetary policy and asset prices when increases in the nation’s cash supply cause prices to rise.

Aside from printing extra bills, governments can stimulate spending by lowering key interest rates. When this happens, investment companies and banks pay less to borrow money from national governments. These institutions can therefore afford to pass their savings onto consumers in the form of low interest rates on credit cards and loans. Generally, consumer spending increases when interest rates on credit products decrease because goods become more affordable. Increased expenditure eventually leads to inflation and this draws attention to the connection between monetary policy and asset prices.

In some situations, excessive inflation can lead to recessions because asset prices rise so high that consumers have to curtail their spending. When this occurs, business revenues drop and employers respond by cutting costs and laying off workers. Consequently, governments often take steps to tighten the money supply. These steps can include increasing interest rates or slowing down the production of new bills. As money becomes scarcer, asset prices drop and a deflationary cycle begins.

Some commodities such as oil and gold are traded on international markets. These commodities are typically priced in United States (US) dollars regardless of where they are sold. Consequently, monetary policy decisions in the United States have a direct impact on the prices of some assets that are sold on other markets throughout the world. Investors in Europe or Asia could gain or lose money as a result of monetary policy decisions made in North America.

Many economists argue that government agencies should not disrupt the ebb and flow of the free market by using policy tools to manipulate the economy. Due to the connection between monetary policy and asset prices, such policies cause some investors to lose money whether governments are attempting to loosen or tighten the money supply. Other economists argue that monetary policy tools enable government agencies to protect consumers from inflationary and deflationary cycles that could otherwise spiral out of control.