ARTICLE IN PRESS

IIMB Management Review (2021) 000, 1–21

available at www.sciencedirect.com

ScienceDirect

journal homepage: www.elsevier.com/locate/iimb

Monetary policy and liquidity: Does investor

sentiment matter?
Byomakesh Debataa,y,*, Saumya Ranjan Dashb, Jitendra Mahakudc

a
Department of Economics & Finance, BITS Pilani, Pilani, Rajasthan, India
b
Finance and Accounting, IIM Indore, Indore, Madhya Pradesh, India
c
Department of Humanities and Social Sciences, IIT Kharagpur, Kharagpur, India

KEYWORDS Abstract We examine the relationship between monetary policy and liquidity effects at the
Investor sentiment; macro (overall market) and micro (individual stocks) levels, using data from the Indian stock
India; market. We also test the possible asymmetric effect of investor sentiment on the monetary pol-
Liquidity; icy – liquidity relationship. Results suggest strong predictability of monetary policy on liquidity
Monetary policy; at an aggregate market level and individual stock level. The effect of monetary policy on liquid-
Emerging stock market ity is stronger during low sentiment (pessimistic) periods as compared to high sentiment (opti-
mistic) periods.
© 2021 Published by Elsevier Ltd on behalf of Indian Institute of Management Bangalore. This is
an open access article under the CC BY-NC-ND license (http://creativecommons.org/licenses/
by-nc-nd/4.0/)

Introduction conditions as a determinant of stock market liquidity has

The sudden liquidity dry-up in the financial markets, particu-
larly during the 2007-2008 global financial crisis, has ampli-
fied the importance of understanding liquidity and its
macroeconomic determinants. The massive monetary policy
interventions carried out by central banks all over the world
to infuse liquidity into the financial system in times of eco-
nomic crisis (Trichet, 2010) further corroborate the argu-
ment. Given the role of the stock market as a monetary
policy transmission mechanism, the impact of monetary pol-
icy on stock market liquidity cannot be ruled out completely.
In recent years, following the seminal work of Chordia, Roll,
and Subrahmanyam (2000) the subject of macroeconomic
*Corresponding author. Phone no. +91-1596515658; +91-7585965885
E-mail addresses: kingbyom@gmail.com, byomakesh.
debata@pilani.bits-pilani.ac.in (B. Debata).
y
Byomakesh Debata was affiliated with the Indian Institute of Tech-
nology Kharagpur, Kharagpur, West Bengal, India, when this paper
was submitted to the journal.
https://doi.org/10.1016/j.iimb.2021.07.001
0970-3896 © 2021 Published by Elsevier Ltd on behalf of Indian Institute of Management Bangalore. This is an open access article under the CC
BY-NC-ND license (http://creativecommons.org/licenses/by-nc-nd/4.0/)
received considerable attention in the finance literature.
However, much less is known about the effects of monetary
policy on stock market liquidity, and whether the impact of
monetary policy on market liquidity is influenced by prevail-
ing market sentiment. Using data from the order-driven
Indian stock market we try to address these two important
issues. Our empirical approach closely follows Ferna
ndez-
Amador, Ga €chter, Larch, and Peter (2013) and
Chowdhury, Uddin, and Anderson (2018) and examines the
relationship between monetary policy and liquidity at macro
level (for overall market) and micro level (for individual
stocks). Given that investor sentiment is an essential ele-
ment in the determination of stock market liquidity
(Liu, 2015; Debata, Dash, and Mahakud (2018), and that
investor sentiment plays a major role in the effect of mone-
tary policy on stock market (Kurov, 2010; Lutz, 2015), it is
intuitive to argue that investor sentiment may play an
important role in the relationship between monetary policy
and stock market liquidity. In line with Chen (2007),
Kurov (2010), and Lutz (2015), we examine the possible

Please cite this article in press as: B. Debata et al., Monetary policy and liquidity: Does investor sentiment matter?, IIMB Management Review (2021), https://
doi.org/10.1016/j.iimb.2021.07.001
 ARTICLE IN PRESS
2 B. Debata et al.
asymmetries in the effects of monetary policy on stock mar-
ket liquidity in different market regimes i.e., periods of high
and low investor sentiment.
We examine the monetary policy effects on the aggregate
stock market liquidity using a vector autoregressive (VAR)
framework and VAR Granger-causality test. We carry out
impulse response functions analysis to elucidate the
response of each stock market liquidity measure for unit
positive shock applied to monetary policy variables. We
carry out variance decomposition to analyse the percentage
of stock market liquidity explained by monetary policy varia-
bles. We use panel fixed effects model to trace the effect of
monetary policy on the liquidity of individual stocks. For
robustness test, we address the issue of the structural break
and carry out empirical analysis using two sub-samples.1 Fol-
lowing the top-down approach of Baker and Wurgler (2006),
we construct a sentiment index using seven implicit orthogo-
nal sentiment proxies and examine the robustness of our
findings during high and low sentiment periods.
We document strong predictability of monetary policy on
liquidity at an aggregate market level, and for individual
stocks. Our findings are consistent with Goyenko and
Ukhov (2009), Ferna
ndez-Amador et al. (2013) and
Chowdhury et al. (2018). Consistent with Goyenko and
Ukhov (2009) and Ferna
ndez-Amador et al. (2013), our
results reveal that an expansionary monetary policy (lower
interest rate or higher money supply) enhances stock market
liquidity. Furthermore, our robustness test results reveal
that investor sentiment plays an important role in the asym-
metric effect on the monetary policy–stock market liquidity
relationship. The effect of monetary policy on liquidity is
stronger during low sentiment (pessimistic) periods as com-
pared to high sentiment (optimistic) periods.
We contribute to and extend the related literature in two
ways. First, to the best of our knowledge the present study is
the first in the Indian context to examine the impact of mon-
etary policy on stock market liquidity at an aggregate market
level, and at firm level using data for individual stocks. As an
out of sample evidence, the estimated results from an
emerging order-driven market help to shed more light on
this issue. Second, our findings also extend the related litera-
ture by providing empirical evidence on the monetary policy
and liquidity relationship, during high and low investor senti-
ment periods. This paper is perhaps the first to suggest a pos-
sible asymmetric effect of investor sentiment on the
monetary policy–stock market liquidity relationship.
The rest of the paper is organised as follows. The succes-
sive sections present a literature review and motivation of
the study; the data and sample characteristics; the mea-
surement of variables; the methodology; the empirical test
1
This paper also addresses the issue of robustness of the results to
several controls for risk. Since, inflow from foreign institutional
investors (FII) constitutes a significant share of the developing mar-
ket transactions (Tillmann, 2013) we use FII as one of our control
variables to control for the liquidity implications of external inflow
of fund. In India for simplicity in reporting statistics, from June 01,
2014, FIIs, Sub Accounts and Qualified Foreign Investors (QFIs) have
been merged into a new investor class termed as Foreign Portfolio
Investors (FPIs). Most of the regulatory agencies (SEBI, RBI, NSDL)
now use the word FPI and FII interchangeably. In this manuscript,
however, we prefer to use the term FII.
Please cite this article in press as: B. Debata et al., Monetary policy and liquidity: Does investor sentiment matter?, IIMB Management Review (2021), https://
doi.org/10.1016/j.iimb.2021.07.001
results; robustness tests; and the last section concludes the
paper.
Related literature and motivation of the study
This section has been divided into two parts. The first part
focusses on the monetary policy and stock market liquidity
relationship. The second part briefly discusses the inter rela-
tionship between monetary policy, stock market liquidity,
and investor sentiment.
Monetary policy and stock market liquidity
Stock market liquidity is becoming a critical issue in capital
market development, financial market stability, and accessing
the expected return variation of a financial asset
(Apergis, Artikis, & Kyriazis 2015 ; Amihud, 2002;
Bekaert, Harvey, & Lundblad, 2007; Jun, Marathe, & Shawky,
2003; Lesmond, 2005; Næs, Skjeltorp, & Ødegaard,2011; Pa
stor
& Stambaugh, 2003). Given the importance of market liquidity
for investment decision and economic policies, identification of
its determinants has been a matter of increased concern.
Recent literature on asset liquidity documents a considerable
co-movement of individual stock’s liquidity, which is known as
commonality in liquidity (Chordia et al., 2000; Huberman &
Halka, 2001; Karolyi, Lee, & Van Dijk, 2012). The observed com-
monality in liquidity supports the notion that there may be
some underlying economic forces or at least a common factor
which concurrently determines the liquidity of all stocks in the
market. In this regard, extant literature suggests that monetary
policy is the most suitable macroeconomic candidate
(Chowdhury et al., 2018; King & Plosser, 1984; Ehrmann &
Fratzscher, 2004; Ferna
ndez-Amador et al., 2013; Friedman &
€
Schwartz, 1963; Nyborg & Ostberg, 2014) to serve the empirical
assessment.
The theoretical linkage between monetary policy and
market liquidity is embedded in the market microstructure
literature. Inventory theory of market microstructure (Has-
brouck, 2007; O’Hara, 1998) proposes that asset inventory
turnover and risk of holding liquid asset inventory affect
market liquidity. Low cost of financing and the low risk of
holding liquid stocks are two fundamental arguments of this
theory. Changes in monetary policy affect the costs associ-
ated with these two features of liquid stock, and hence,
monetary policy is likely to affect stock market liquidity.
The monetary stance of the central bank can influence the
market liquidity by altering the borrowing constraint, and
funds flow into the stock market (Garcia, 1989; Brunnerme-
ier & Pedersen, 2009). The Brunnermeier and Peder-
sen (2009) model suggests that market participants with
capital constraints find it difficult to meet their margin
requirements, and, in turn, fail to provide liquidity. Con-
versely, corrosion of market liquidity increases the cost of cap-
ital, which reduces traders’ funding liquidity. Following these
arguments, an expansionary (contractionary) monetary policy
is anticipated to reduce (increase) the cost of margin borrow-
ing of traders and facilitate (deter) funding liquidity.
There are several motivating factors for this research.
There is a limited amount of research available on the rela-
tionship between monetary policy and stock market liquidity
in the pure order-driven market. Available research work
 ARTICLE IN PRESS
Monetary policy, investor sentiment and liquidity
(Chordia et al., 2005; Ferna
ndez-Amador et al., 2013;
Goyenko & Ukhov, 2009; Soderberg, 2008) has been mainly
focussed on developed markets, which are primarily quote-
driven or are hybrid markets. Order-driven markets have a
substantially different market microstructure, and their
behaviour is very different (Brockman & Chung, 2002;
Ma, Anderson, & Marshall, 2016). Order-driven markets gen-
erate liquidity demand and supply schedules that are consis-
tent with equilibrium under perfect competition (Brockman
& Chung, 2002). Examination of this relationship in a pure
order-driven market may provide different results or fresh
insights.
The empirical literature on the impact of monetary policy
on stock market liquidity has mixed evidence. Goyenko and
Ukhov (2009) obtained strong evidence for predictability of
monetary policy on stock market liquidity for the U.S. mar-
ket for the period 1962-2003. Their study reveals that an
expansionary monetary policy, which is reflected in an
increase in non-borrowed reserves and a decrease in federal
fund rate, enhances market liquidity. Chordia et al. (2005)
documented that the monetary policy influences market
liquidity only in the crisis period for all stocks listed on the
NYSE. Soderberg (2008) derived mixed evidence of predict-
ability of macroeconomic variables on market liquidity for
Scandinavian stock exchanges. The study unveils that policy
rate predicts market liquidity in the Copenhagen stock
exchange, the broad money growth rate in the Oslo stock
exchange, and short-term interest rate and mutual fund
flow predict liquidity in the Stockholm stock exchange.
Soderberg (2008) observed that there is no common deter-
minant which can forecast market liquidity for all the three
stock exchanges. Ferna
ndez-Amador et al. (2013) provided
similar evidence in the context of the Eurozone. Their study
documents that expansionary monetary policy decisions of
the European Central Bank enlarge the overall stock market
liquidity in German, French, and Italian markets.
In the preceding paragraphs, we have argued to establish
the importance of revisiting the monetary policy–stock mar-
ket liquidity relationship using an emerging, order-driven
market data. Existing literature has been unable to provide
consistent empirical evidence due to the variation in sample
periods, liquidity and monetary policy proxies, and market
focus, which makes the comprehensive interpretation of
empirical evidence difficult. Moreover, the existing empiri-
cal literature primarily focusses on developed markets,
which are arguably the most liquid in the world. There is a
paucity of research in the context of emerging markets. The
available study in the context of China (Chu, 2015) reveals
the asymmetric effects of monetary shocks on stock market
liquidity. However, the findings of the study fail to provide
any insight on firm-specific liquidity and monetary policy.
The long-term impact of the liquidity of emerging equity
markets for investment management and portfolio diversifi-
cation has received considerable attention in recent years.
There is a growing unanimity among academic researchers
and practitioners that each emerging market economy is
unique, with its market structure, regulatory environment
and levels of market development (Bekaert & Harvey, 2003).
Emerging markets are characterised by low liquidity
(Bekaert et al., 2007; Domowitz, Glen, & Madhavan, 2001;
Jun et al., 2003; Ma et al., 2016), and can influence the port-
folio performance due to high liquidity premium expectation
Please cite this article in press as: B. Debata et al., Monetary policy and liquidity: Does investor sentiment matter?, IIMB Management Review (2021), https://
doi.org/10.1016/j.iimb.2021.07.001
3
(Lesmond, 2005). As documented by Lo and Mackin-
lay (1990), an out-of-sample experiment can test whether
findings in the developed markets should be acknowledged
as a worldwide phenomenon. The difference in the structure
of emerging economies and their policy environment makes
it imperative to have out-of-sample empirical evidence from
an emerging market on the monetary policy–liquidity rela-
tionship. The Indian stock market serves as an ideal candi-
date for this examination.
Over the past two decades, the Indian capital market has
made remarkable progress in terms of market size and
liquidity. With regard to security listing, the Indian capital
market has become the second largest in the world. The size
of the Indian stock market (market capitalisation to GDP
ratio) has risen from 17.83% in 1991 to 72.4% in 2015 (The
World Development Indicator, 2016). From the existing liter-
ature it also emerges that the monetary policy transmission
mechanism in developing countries is dependent on the
development of the financial system, level of internal mar-
ket integration, bank or market-based financial system, cen-
tral bank autonomy, capital inflows, government spending,
and exchange rate flexibility (for e.g., Rankel, 2010; Jain-
Chandra & Unsal, 2014; Kandil, 2014; Klein &
Shambaugh, 2015; McGettigan et al., 2013; Mohanty &
Turner, 2008, among others). Given the heterogeneity of
central banks’ monetary policy transmission effectiveness in
developed and emerging economies (Coulibaly, 2012;
Frankel, 2010; Kamin, Turner & Van’t dack, 1998; Mishra &
Montiel, 2013; Mohanty & Turner, 2008), the impact of mon-
etary policy on stock market liquidity needs distinctive
attention in the context of emerging markets. In conjunction
with the economic reforms initiated since 1991, India’s mon-
etary policy framework has undergone significant change. It
has switched over from monetary targetting regime (in the
mid-1980s) to multiple indicator regimes (1998-99) and is
presently focussing on inflation targetting (Mishra & Mis-
hra, 2012). Concurrently, the focus of monetary policy
shifted from direct instruments such as selective credit con-
trols and cash reserve ratio to indirect instruments such as
repo operation under liquidity adjustment facility and open
market operation (Prabu, Bhattacharyya, & Ray, 2016). It
has shifted from a primarily regulated economy to a market-
based economy, enlarging the scope of a market-oriented
approach for monetary policy formulation. However, in the
context of the Indian monetary policy environment, while
the transmission of monetary policy to money market is
found to be quick and efficient and the effects on bond and
forex market are on expected lines, the impact of monetary
policy on stock market is limited (Ray & Prabu, 2013). In
India, the effectiveness of monetary policy, however,
remains constrained by several country-specific factors that
affect transmission of the policy impulses through the inter-
est rate channel (Patel et al., 2014). Since financial markets
in emerging economies are highly segmented and less
mature compared to those in developed countries, it is
worthwhile to understand the monetary policy and liquidity
relationship using data from an emerging market which is
less correlated with the established market.
To sum up, the review of the existing literature does not
find any consensus on whether monetary policy predicts
stock market liquidity. The monetary policy instrument that
can be considered a suitable candidate to validate the
 ARTICLE IN PRESS
4 B. Debata et al.
impact of monetary policy on stock market liquidity is not
yet settled upon in the related literature. The effect of mon-
etary policy on market liquidity varies across markets and
periods. Moreover, a limited number of empirical studies
have examined the interrelationship between the monetary
policy environment and market liquidity in the emerging
economies. Thus, the assessment of monetary policy impact
on stock market liquidity using an out of sample order-driven
emerging market data helps us to extend the related litera-
ture for a better understanding of this critical issue.
Investor sentiment, monetary policy, and stock
market liquidity
Behavioural finance takes a distinctive approach to study
how psychological phenomena impact investment behaviour
of market participants. From this perspective, the role of
investor sentiment for pricing of risky financial assets has
gained considerable attention in finance literature. Behav-
ioural finance literature suggests that since all investors fail
to hold objectively correct beliefs about the fundamental
price because of inherent behavioural biases
(Barberis, Shleifer, & Vishny, 1998; Baker & Nofsinger, 2002),
the demand shifts induced by irrational speculation or noise
trading (De Long, Shleifer, Summers, & Waldmann, 1990) in
a state of arbitrage and short-sell constraint (Shleifer &
Vishny, 1997; Kyle, 1985) generates systematic sentiment
risk (Shefrin, 2005). A large and growing body of behavioural
finance literature suggests that when arbitrage is limited,
noise trader sentiment can persist in financial markets
(DeLong et al., 1990; Shleifer & Vishny, 1997) and affect
expected return, liquidity, and volatility of financial asset
such as stocks (Baker & Wurgler, 2006; Dash, 2016;
Debata et al., 2018; Liu, 2015; Shen, Yu, & Zhao, 2017). Con-
sistent with the scope of this paper, in the following para-
graphs we will focus on the two important aspects of
investor sentiment: (i) the relationship between investor
sentiment and market liquidity, (ii) investor sentiment
and monetary policy.
Existing studies support a positive (negative) relationship
between investors sentiment and contemporaneous
(expected) stock returns because of the overvaluation
(undervaluation) in the stock prices (Baker & Wurgler, 2006).
Moreover, irrational sentiment influences stock valuations
and certain category of stocks are disproportionately sensi-
tive to sentiment effect. On similar lines, higher investor
sentiment may affect market liquidity (Baker & Stein, 2004;
Liu, 2015; Debata et al., 2018) through two channels: noise
trading (De Long et al., 1990; Huberman & Halka, 2001) and
irrational investor behaviour (Kyle, 1985; Statman et al.,
2006; Shefrin & Statman, 1985). Consistent with such theo-
retical arguments, existing literature asserts that positive or
bullish (negative or bearish) investor sentiment increases
(decreases) stock market liquidity (Liu, 2015; Debata et al.,
2018).
A number of recent studies extend the argument of
behavioural finance to understand the monetary policy and
investor behaviour relationship. An early study by
Chen (2007) documented that monetary policy has an asym-
metric effect on the market and that the effect of monetary
Please cite this article in press as: B. Debata et al., Monetary policy and liquidity: Does investor sentiment matter?, IIMB Management Review (2021), https://
doi.org/10.1016/j.iimb.2021.07.001
policy on stock returns is influenced by the state of the mar-
ket i.e., bull (optimistic) or bear (pessimistic) market. Spe-
cifically, monetary policy has larger effects on stock returns
in bear markets, and a contractionary monetary policy leads
to a higher probability of switching to the bearmarket
regime. Hence, the transmission of monetary policy signals
to stock market is influenced by whether a large number of
investors in the market are bullish or bearish. In later studies
Kurov (2010) and Lutz (2015) documented that monetary
policy decisions have a significant effect on investor senti-
ment. Kurov (2010) found that the effect of monetary news
on sentiment depends on market conditions (bull versus
bear market), and monetary policy actions in bear market
periods have a larger effect on stocks that are more sensitive
to changes in investor sentiment. Validating the relationship
between sentiment and monetary policy further, Lutz (2015)
highlighted the importance of both conventional and uncon-
ventional monetary policy in the determination of investor
sentiment.
It is therefore established that prevailing market senti-
ment can be an important aspect that influences market
liquidity and monetary policy transmission to the stock mar-
ket. However, there is no study that highlights the impor-
tance of investor sentiment in influencing the monetary
policy–stock market liquidity relationship. If investor senti-
ment can individually influence the market liquidity and
monetary policy transmission, then it is plausible to argue
that investor sentiment can be an important parameter to
influence the effect of monetary policy on stock market
liquidity. To our knowledge there is no study to address this
issue. In our paper, using data from the Indian stock market,
we attempt to fill this gap in the existing literature.
Chowdhury et al. (2018) using data from the Indian stock
market analysed the monetary policy-liquidity relationship,
but the study is silent on the aspect of investor sentiment
and market liquidity relationship. Our paper therefore pro-
vides a more comprehensive examination of monetary pol-
icy–liquidity relationship in terms of its sample size,
alternative liquidity proxies, and most important, its focus
on the role of investor sentiment.
Data
In our study, we considered stocks listed on the National
Stock Exchange (NSE) of India for the sample period April
2002 to March 2015. To avoid any impact of the transition
from two different trading systems in the Indian stock mar-
ket, we chose April 2002 as the starting point of our sample
period. The Security Exchange Board of India (SEBI) abol-
ished the “badla system” in July 2001 and introduced the
rolling settlement cycle (T+2) to facilitate transparency,
efficiency, and immediacy. Following Chordia et al. (2005),
we set the following criteria to select stocks for our study:
(i) The stock was required to be present and should have
been continuously traded throughout the sample period (i.
e., April 2002 to March 2015). The stock had to disseminate
daily trading information (ii) Stocks which were not actively
traded in the market were excluded from our sample. (iii) To
avoid the influence of unusually high-priced stocks, we
excluded stocks with abnormally high value at the end of
 ARTICLE IN PRESS
Monetary policy, investor sentiment and liquidity
any month in a year. We found 510 firms conforming to the
stock selection criteria, and hence they constituted our
study sample. We collected the daily high price, low
price, open price, and closing price for all selected
stocks to determine daily return, daily volatility, and
liquidity proxies. Then, the daily measures were aver-
aged out to construct a monthly proxy as most of the
macroeconomic variables were available at a monthly
frequency. The total number of observations for time
series analysis is 156 monthly observations, and the num-
ber of observations in panel data is 79560. Stock prices
and other firm-specific variables were collected from the
Bloomberg database. The macroeconomic fundamentals
data were obtained from the Handbook of Statistics on
Indian Economy (2016) published by the Reserve Bank of
India (RBI).2
Variables and descriptive statistics
This section has been divided into four parts discussing the
liquidity variables, the monetary policy variables, the con-
trol variables, and the investor sentiment variables.
Liquidity variables
Liquidity is a broad and elusive concept (Amihud, 2002;
Pa
stor & Stambaugh, 2003); one that is not observed
directly and which has a number of aspects that cannot
be captured in a single measure (Amihud, 2002). Liquid-
ity, by its very nature, is difficult to measure because it
encompasses a number of transactional properties of the
underlying asset (Kyle, 1985; Lesmond, 2005). Stock mar-
ket liquidity has multiple dimensions, such as tightness
(the ability to buy or sell a security about the same
price), depth (the ability to buy or sell certain quantity
of securities without any impact on quoted prices),
immediacy (the velocity with which a transaction gets
executed) and resiliency, which reflects how quickly asset
prices revert to the previous level after a particular
quantity of transaction (Kyle, 1985; Sarr & Lybek, 2002).
Following such argument, available literature suggests
several alternative measures of liquidity to capture its
multidimensional nature, and each measure can capture
a specific aspect of the liquidity such as immediacy, trad-
ing cost, trading quantity, trading speed, and price
impact (Amihud & Mendelson, 1986; Amihud, 2002;
Brenan, Chordia, & Subrahmanyam, 1998; Chordia et al.,
2001; Datar, Naik, & Radcliffe, 1998; Goyenko, Holden, &
Trzcinka, 2009; Korajczyk & Sadka, 2008; Lesmond, 2005;
Liu, 2006; Pastor & Stambaugh, 2003). The selection of
liquidity proxies is a major challenge as the effectiveness
of these proxies may vary across different market struc-
tures and financial market development. It is therefore
imperative to consider alternative proxies of liquidity in
order to have a sound inference of empirical results.
Consistent with related literature (Amihud & Mendel-
son, 1986; Amihud, 2002, Florackis, Gregoriou, & Kosta-
kis, 2011; Corwin & Schultz, 2012) we have employed
2
https://www.rbi.org.in/scripts/AnnualPublications.aspx?
head=Handbook%20of%20Statistics%20on%20Indian%20Economy
Please cite this article in press as: B. Debata et al., Monetary policy and liquidity: Does investor sentiment matter?, IIMB Management Review (2021), https://
doi.org/10.1016/j.iimb.2021.07.001
5
five different liquidity proxies to capture various attrib-
utes of liquidity such as trading activity (traded value
and turnover ratio), price impact (Amihud’s illiquidity
ratio and turnover price impact ratio), and transaction
costs (high-low spread estimator). The detailed descrip-
tion of liquidity proxies used in this study is shared as
supplementary material accompanying the online ver-
sion of the article (Table S1)
Monetary policy variables
We have approximated the monetary policy stance of the
central bank through monetary aggregate and interest rate.
Taking a cue from Ferna
ndez-Amador et al. (2013) and
Chowdhury et al. (2018), we employ rolling twelve-month
reserve money growth rate (RM) as a proxy of the monetary
aggregate. The selection of 12-month lag for the growth
rate calculation is consistent with the approach of Ferna
n-
dez-Amador et al. (2013) for European countries and
Chowdhury et al. (2018) for emerging economies.3 We chose
reserve money because it is very easily affected by the pol-
icy decisions of monetary authority.
RMt  RMt12
Reserve money growth rate ¼  100
RMt12
It is also evident from the extant literature that inter-
est rate has emerged as a crucial information variable for
financial markets (Dhal, 2000). Consistent with related
literature we use monthly weighted average call money
rate (CMR) as a measure of monetary stance. In the con-
text of India, the change in call-money rate reflects the
dynamics of demand and supply of overnight liquidity
requirement. 4 We are motivated to choose CMR as an
approximation of monetary policy due to its recognition
as the operating target of monetary policy by the RBI.
3
While transmission is weaker in case of emerging economies, it is
not clear if the transmission lags are longer (Patel et al., 2014). For
instance, the available empirical evidence for the monetary trans-
mission channel in India suggests that monetary policy actions are
felt with a lag of 2-3 quarters on output, and with a lag of 3-4 quar-
ters on inflation, and the impact persists for 8-12 quarters
(Patel et al., 2014). The lags of 2-4 quarters are the average lags
over the sample periods of various studies (Acharya, 2017). The
actual lags at any given point of time could be vastly different from
these average lags, depending upon factors such as the macroeco-
nomic conditions, stage of the domestic business cycle, the domes-
tic liquidity, financial conditions, the fiscal stance, and the health of
the domestic banking sector (Acharya, 2017). Considering the aver-
age lags of 2-4 quarters in the context of India (Acharya, 2017), in
our study we assume a four quarter or one-year long horizon to
approximate the change in reserve money growth rate (RM). Albeit
in an informal way, the rationality of 12-month lag for the reserve
money growth rate calculation is also motivated from two other
aspects. First, consistency of our approach with related literature
for e.g., Chowdhury et al. (2018) for emerging markets. Second,
simplicity from computational aspect and consistency with the
reporting parameters of the central bank of India. The RBI publica-
tions for the components of money stock, select economic indica-
tors, and reserve money, components and sources prefer to measure
the year–on–year growth rate of reserve money following a 12-
month horizon.
 ARTICLE IN PRESS
6 B. Debata et al.
Control variables
A related strand of literature supports the fact that macro-
economic fundamentals influence the liquidity of financial
securities to a large extent (Eisfeldt, 2004; Naes et al.,
2011; Soderberg, 2008, among others). For instance,
Goyenko and Ukhov (2009) assert that a positive shock to
inflation increases inventory holding and order-processing
cost, which in turn, increases the overall transaction cost
and leads to decrease in stock market liquidity. Similarly,
Naes et al. (2011) establish a strong relationship between
business cycle and stock market liquidity. It has also been
observed that inflationary conditions and current economic
scenario play a significant role in the monetary policy formu-
lation. Motivated by these findings, we include the twelve-
month growth rate of inflation (IR) and industrial production
growth rate (IP) in our study as macroeconomic control vari-
ables. Considering the significant role of FIIs in the Indian
stock market,5 we include FII as another macroeconomic
control variable. The FII inflows may reduce the cost of capi-
tal, supplement domestic savings, and capital formation in
emerging economies such as India. As a result, the cost of
margin borrowing will be less, which may further lower the
transaction cost and enhance liquidity. Further, following
Ferna
ndez-Amador et al. (2013), we perceive the possible
interdependence of liquidity and cyclical movement in the
stock market and incorporate the benchmark NSE Nifty 50
index return (INDEX) in our study.
Related literature on market microstructure has docu-
mented that individual firm characteristics may influence
stock liquidity. For example, Brunnermeier and Peder-
sen (2009) and Hameed, Kang, and Viswanathan (2010)
ascertain that the past return from stocks significantly
affects stock liquidity. Similarly, stock volatility is inversely
related to stock liquidity (Copeland & Galai, 1983). Consis-
tent with such arguments, we consider firm specific stock
return (RET) and stock return volatility (STDV) as control
variables. In our panel model, we use the lagged value of
monthly stock return (RET) and lagged value of the monthly
standard deviation of stock return (STDV) as control varia-
bles. For time series analysis, we compute monthly market
return (RET) as the equally weighted average monthly return
of individual stocks and return volatility (STDV) as the
monthly standard deviation of equally weighted average
daily stock return. Amihud (2002) suggests that the impact
of illiquidity shocks on large size firms is less pronounced as
compared to the small size stocks. Following this reasoning,
one can also argue that the effect of monetary policy varia-
bles on stock liquidity may differ concerning the size of the
firm. Thus, we include firm size (SZ) as another firm-specific
control variable in the panel model. We measure SZ as the
natural logarithm of the market capitalisation.
The summary statistics and correlation matrix of liquidity
variables (TV, TR, ILLIQ, TPI, HLS), monetary policy variables
(CMR, BM), and control variables (IP, IR, FII, STDV, RET, SZ,
4 down approach of Baker and Wurgler (2006) to construct a
Similar to Fed rate for the US and Euro overnight index average for
the Euro Central Bank.
5
The post economic liberalisation period has witnessed a rapid
growth in the flow of FII to India. It has increased from US$ 1635 mil-
lion during 2002-03, to US$ 226,103 million in the financial year
2014-15 (SEBI, 2015).
Please cite this article in press as: B. Debata et al., Monetary policy and liquidity: Does investor sentiment matter?, IIMB Management Review (2021), https://
doi.org/10.1016/j.iimb.2021.07.001
INDEX) are presented in Table 1. Panel A shows the descrip-
tive statistics. Panel B depicts the correlation structure
among the variables. Some interesting observations ema-
nate from the correlation matrix. The liquidity measures (TV
and TR) are negatively associated with STDV and have a posi-
tive relationship with RET. The negative correlation with
STDV suggests that volatility of stock returns can be perceived
as an indicator of illiquidity. Similarly, the positive correlation
between RET and liquidity proxies shows that stock return is an
increasing function of liquidity. We find a negative correlation
between the trading activity measures of liquidity (TV and TR)
and price impact measures (ILLIQ and TPI). A similar relation-
ship has also been observed between the measures of trading
activity and transaction costs (HLS). This indicates that higher
trading activity translates into increased liquidity of stocks;
however, the increase in the cost of transaction or price impact
reduces the liquidity of financial assets. Panel (B) of Table 1
reveals less degree of correlation among liquidity measures.
This could be due to the fact that liquidity is multidimensional
in nature and the employed liquidity proxies measure different
aspects of liquidity and do not represent the same sets of infor-
mation. We observe a positive association between money sup-
ply (RM) and trading activity, and a negative correlation
between trading activity and interest rate (CMR). We can
hypothesise that an increase in money supply may boost trading
activity, and hence, creates liquidity in the market.
Before estimating the VAR model, we carried out aug-
mented Dickey-Fuller (1981) (ADF), Phillips-Perron (1988)
(PP), and Kwiatkowski, Phillips, Schmidt, and Shin (KPSS)
(1992) unit root tests to examine stationarity of varia-
bles. The optimal lag for ADF test and truncation lag for
PP test are selected based on the Akaike information cri-
terion (AIC) and Schwarz information criterion (SIC) crite-
ria. The unit root tests reveal that the null hypothesis of
unit root is rejected for all the liquidity measures, mac-
roeconomic variables, volatility and stock returns at first
difference (with and without intercept and trend). Since
most of the liquidity variables are stationary at first dif-
ference, we have reported the unit root test statistics at
the first difference only. Another motivation of use of
variables in first difference is that it reduces the problem
of serial correlation and trending of data to a large
extent (Wooldridge, 2002). Thus, we have used the varia-
bles in their first difference in our model. The unit root
tests result for ADF, PP and KPSS are shared as supple-
mentary material accompanying the online version of
the article (Table S2). The Inclan and Tiao (1994) struc-
tural break test reveals that there is no sudden shift or
trend break in the time series. For the purpose of brev-
ity, we do not report Inclan and Tiao (1994) structural
break test results.
Investor sentiment
We measure investor sentiment (SENT), following the top-
sentiment index. Using seven implicit sentiment proxies i.
e., advance decline ratio (ADR), put-call ratio (PCR), num-
ber of IPOs (NIPO), dividend premium (DP), mutual fund flow
(FF), mutual fund cash to total assets (CTA), and NSE Nifty
50 market turnover (TOV) we construct a sentiment index
 Monetary policy, investor sentiment and liquidity
Table 1 Summary statistics and correlation matrix

Panel A: Summary statistics

TV TR ILLIQ TPI HLS CMR RM IP IR FII STDV RET SZ INDEX
Mean 15.71 10.16 0.444 0.055 0.014 6.236 14.359 6.069 5.917 1.750 7.887 0.125 9.108 8.183
Median 16.04 10.20 0.274 0.046 0.013 6.050 14.516 6.056 6.000 1.361 7.735 0.147 9.011 8.428
Maximum 17.33 11.43 1.950 0.179 0.037 14.070 18.953 19.981 9.100 9.990 20.077 1.502 15.24 9.094
Minimum 12.04 8.158 0.001 0.028 0.006 0.730 -2.167 -7.242 -2.30 -5.495 1.109 -1.72 -4.422 6.839
Std. dev. 1.264 0.692 0.488 0.025 0.004 1.934 7.038 5.419 2.819 2.709 4.123 0.456 1.994 0.611
Skewness -1.288 -0.760 1.560 2.273 1.790 0.339 0.326 0.258 -0.45 0.371 0.926 -0.21 0.258 -0.777
Kurtosis 4.033 3.575 4.805 6.204 5.269 3.813 2.660 3.046 3.140 3.400 4.304 4.791 2.752 2.466
Panel B: Correlation matrix
TV TR ILLIQ TPI HLS CMR RM IP IR FII STDV RET SZ INDEX
TV 1.000

ARTICLE IN PRESS
TR 0.860 1.000
ILLIQ -0.250 -0.24 1.000
TPI -0.411 -0.146 0.130 1.000
HLS -0.383 -0.036 0.191 0.240 1.000
CMR -0.297 -0.720 0.670 0.334 0.600 1.000
RM 0.106 0.169 -0.310 -0.027 -0.06 -0.310 1.000
IP 0.073 0.153 -0.037 -0.009 0.015 -0.377 0.714 1.000
IR -0.040 -0.008 0.005 0.056 0.005 -0.206 0.385 0.160 1.000
FII 0.067 0.132 -0.029 -0.056 -0.017 -0.136 0.052 0.161 -0.105 1.000
RET 0.00-__8 0.011 -0.016 -0.301 -0.001 -0.011 -0.089 -0.049 -0.141 0.035 1.000
STDV -0.053 -0.058 0.009 0.012 0.012 0.067 0.038 -0.003 -0.011 -0.013 -0.021 1.000
SZ 0.614 0.820 -0.034 -0.104 -0.115 0.011 -0.022 -0.023 -0.001 -0.002 -0.012 0.61 1.000
INDEX 0.224 0.175 -0.017 -0.126 -0.055 -0.375 0.691 -0.165 0.063 -0.012 0.791 0.188 0.012 1.000
Note: This table represents the descriptive statistics and correlation matrix of liquidity variables i.e., traded value (TV), turnover ratio (TR), illiquidity ratio (ILLIQ), turnover price impact
(TPI), high-low spread (HLS); monetary policy variables i.e., call money rate (CMR), reserve money growth rate (RM); macroeconomic control variables i.e., industrial production growth rate
(IP), inflation rate (IR), the net funds flow from foreign institutional investors (FII), and return from CNX Nifty 50 index (INDEX). Firm specific control variables include firm size (SZ), monthly
stock return (RET), and standard deviation of return (STDV). Sample period consists of 156 monthly observations from April 2002 till March 2015.

7
 ARTICLE IN PRESS
8 B. Debata et al.
(SENT) following the approach of Baker and Wurgler (2006).
Considering the theoretical arguments in related literature6
the sentiment index (SENT) can be presented as:
SENTt ¼ ADRt  PCRt þ NIPOt  DPt þ FFt  CTAt þ TOVt
We orthogonalise each of the sentiment variables using fun-
damental factors (reserve money growth rate, term spread,
inflation growth rate, industrial production growth rate,
short term interest rate, and FII inflow). The error term of
the orthogonal equation has been considered as proxy for
irrational component of investor sentiment. We also use the
approach of Baker and Wurgler (2006) to capture the rela-
tive timing of each of the orthogonal sentiment proxies for
the construction of the SENT index. We use first principal
components analysis for measuring the common variation
among the orthogonal sentiment proxies (Equation 1.1).
SENTt ¼ ð0:398ÞADRt1  ð0:025ÞPCRt1
þ ð0:557ÞNIPOt  ð0:256ÞDPt
þ ð0:643ÞFFt1  ð0:138ÞCTAt1
þ ð0:176ÞTOVt1
The high (low) sentiment periods are characterised as the
periods in which the sentiment index values are greater
(lesser) than the median sentiment value. The high (low)
sentiment period resembles optimistic (pessimistic) market
sentiment periods.
Model specifications and methodology
This section presents model specifications and methodology
in two separate sub-sections. First, to study the relationship
between monetary policy and aggregate stock market liquid-
ity we employ a vector auto-regressive (VAR) model. Second,
to elucidate the impact of monetary policy on individual
stock liquidity, we use panel regression models. In addition,
we carry out Iterative Cumulative Sum Square (ICSS) break
test (Inclan and Tiao, 1994) to identify any trend break or
shift during our study period.
6
Interpretation of implicit sentiment proxies is consistent with
related literature (Baker & Wurgler, 2006; Dash, 2016;
Debata et al., 2018). For instance, ADR: the ratio of the number of
advancing and declining stock prices. It helps to measure strength
of the market regarding aggregate buying and selling. A higher ratio
indicates positive sentiment. PCR: the ratio of number of put
options to number of call options. Higher (lower) ratio suggests
bearish (bullish) sentiment as investors execute more sale orders
following a negative sentiment in the market. NIPO: A large number
of initial public offerings (IPOs) in a particular month suggests a pos-
itive sentiment. DP: Difference of the average market-to-book
ratios of dividend payer and non-payer stocks, and this measure is
negatively related to the market sentiment. FF: Fund flows into
equity funds and suggests a positive sentiment indicator. CTA: ratio
of total cash balance of mutual fund companies to total asset. A
high (low) value of the ratio suggests pessimism (optimism) about
the market. TOV: Market turnover ratio is considered to be a mea-
sure of overvaluation in the market and hence a positive sentiment
indicator.
Please cite this article in press as: B. Debata et al., Monetary policy and liquidity: Does investor sentiment matter?, IIMB Management Review (2021), https://
doi.org/10.1016/j.iimb.2021.07.001
Time series estimation
The VAR model helps to understand the relationship between
economic variables by capturing the linear interdependency
among the variables (Sims, 1980). It evolved as an alterna-
ð1Þ tive to simultaneous equation models. Unlike the classical
simultaneous equation models, VAR is free from any arbi-
trary restriction. Sims (1980) highlights that if there exists
any simultaneity among the variables, then there should not
be any distinction between endogenous and exogenous vari-
ables and all variables are considered to be endogenous.
Thus, each equation will have the same number of regressors
which leads to the development of VAR models.
Though the pertinent literature has partially explained
the univariate relationship between macroeconomic funda-
mentals, market variables, and stock market liquidity, there
are good reasons to expect a bi-directional relationship
among them. For example, investors demand a higher
expected return for holding illiquid stock in equilibrium
(Amihud & Mendelson, 1986). However, it has also been
argued that the return from a stock signals the future trad-
ing behaviour, which in turn, affects stock liquidity. In the
same direction, Gracia (1989) highlights the importance of
monetary policy decisions to infuse liquidity into the mar-
ð1:1Þ ket, particularly during crisis periods as a minimum level of
liquidity is required for smooth functioning of financial mar-
kets. Hence, stock market liquidity may be a function of
macroeconomic variables. On the other hand,
Naes et al. (2011) posit that stock market liquidity is a lead-
ing indicator of the real economy and sudden drying-up of
liquidity in financial markets is a precursor to crisis or dis-
tress in the real economy. Based on these arguments, we
expect an endogenous relationship between stock market
liquidity and indicators of the real economy. To investigate
the relationship between monetary policy and aggregate
market liquidity, we employ a VAR model consistent with
Chordia et al. (2005) and Goyenko and Ukhov (2009). The
specification of the VAR model is as follows:
Xm Xm
Xt ¼ a1 þ a  Xti þ b  Yti þ ut ð2Þ
i¼1 1i i¼1 1i
Xm Xm
Yt ¼ a 2 þ i¼1
b2i  Yti þ i¼1
a2i  Xti þ vt ð3Þ
where X vector represents the monthly stock market liquid-
ity measures at time t-i. Y vector represents the monthly
measures of monetary policy and control variables (macro-
economic as well as market variables) at time t-i. i repre-
senting the minimum lag length, a1i and a2i are the
coefficients of lagged value of X vector, and b1i and b2i ; the
coefficients of lagged value of Y vector, ut and vt are the
error terms of equation (2) and (3), respectively. This model
examines whether stock market liquidity and monetary pol-
icy are linked together and whether any spontaneous change
in monetary policy influences stock market liquidity. To
choose the optimal lag length m, we have employed AIC and
SIC. Although the two criteria show different lag lengths, we
have chosen the smaller one to retain the maximum number
of degrees of freedom.
Despite its usefulness, the VAR model suffers from certain
key limitations. First, the involvement of a large number of
parameters in the model makes it difficult to interpret. Sec-
ond, the sign of the coefficients of lagged variables changes
 ARTICLE IN PRESS
Monetary policy, investor sentiment and liquidity
across different lags. That makes it difficult to ascertain the
effect of a given change in a variable upon the future values
of the variables in the system. To overcome these weak-
nesses, we use the VAR model along with the VAR-Granger
causality test (Granger, 1969; Sims, 1980), impulse response
functions (IRF) and variance decomposition tests. The
Granger-causality test enables us to know the direction of
causality (unidirectional or bidirectional causality) between
stock market liquidity and monetary policy. IRF traces the
impact of a unit shock applied to one of the endogenous vari-
ables on the current and future values of other endogenous
variables. IRF traces the response of stock market liquidity
for one positive shock applied upon the residuals of mone-
tary policy. IRF helps to capture the sign, magnitude, and
persistence of responses of stock market liquidity measures
to shocks in monetary policy variables. Taking cues from the
related literature, we use the standard Cholesky decomposi-
tion of VAR residuals and place the variables in the order
they influence each other. We further examine the predict-
ability of monetary policy by employing variance decomposi-
tion. Variance decomposition explains the percentage of
variation in the dependent variable not only due to its own
shock, but also to the shocks in other variables. Variance
decomposition analysis explains the proportion of variation
in stock market liquidity due to innovations in monetary pol-
icy and other control variables.
Panel-regression model
Consistent with Ferna
ndez-Amador et al. (2013), we employ
panel-regression models to investigate the effect of mone-
tary policy on liquidity of individual stocks. The model is
specified as follows:
LIQjt ¼ cj þ a1 LIQjti þ a2 MPti þ a3 Xjti þ a4 Yjti þ ejt
ð4Þ
where j stands for j cross-sectional unit and t for the tth
th
time period, and c is the intercept term. Slope coefficients
are represented by a1, a2, a3 and a4; ejt is the error term
which is assumed to have mean zero and constant variance.
LIQjt stands for the five liquidity measures (TV, TR, ILLIQ,
TPI, and HLS) of the stock j in month t. The monetary policy
variables (CMR and RM) at time t are represented byMPti.
The vector Xjti represents the firm-specific control varia-
bles, such as RET, STDV, SZ. The macroeconomic control vari-
ables, i.e., IPti , IRti , FIIti and the INDEXti are
represented by the vector Yjti. In our study, we have used a
balanced panel data set as panel data has a number of
advantages over conventional time-series, or cross-sectional
data in that panel estimation helps to control individual het-
erogeneity (Moulton, 1986, 1987). The use of firm-specific
variable in our model also helps to overcome the problem of
simultaneity or firms’ heterogeneity. We employ AIC and SIC
criteria to choose the suitable lag length i. Likelihood ratio

roux, Holly, & Monfort,1982) has been car-
(LR) test (Gourie
ried out to identify the existence of individual firm-specific
effects in the data set. Lagrange multiplier (LM) test
(Breusch & Pagan, 1980) has been used to check the accept-
ability of panel data models over classical regression mod-
els. Hausman test (Hausman, 1978) has been conducted to
choose a suitable panel data model such as the fixed-effect
Please cite this article in press as: B. Debata et al., Monetary policy and liquidity: Does investor sentiment matter?, IIMB Management Review (2021), https://
doi.org/10.1016/j.iimb.2021.07.001
9
or random-effect model. The use of a fixed-effect model
allows the intercept to vary over the individual firms, while
the slope coefficients remain constant.
Results discussion
This section discusses the empirical findings of monetary pol-
icy implications on stock liquidity at the aggregate market
level as well as individual stocks level.
Monetary policy and stock market liquidity
This section deals with the empirical findings of the VAR-
Granger causality test, IRF, and variance decomposition to
ascertain the relationship between monetary policy and
stock market liquidity. It also addresses the trend break issue
during the study period. First, we report the Granger-causal-
ity test, IRFs, and variance decomposition. The VAR exam-
ines the relationship between stock market liquidity and
monetary stance. This approach entails a total of 10 differ-
ent VAR estimates, each of which allows for 42 Granger-cau-
sality tests. For brevity, we report only the Granger-
causality tests between five liquidity proxies and two mone-
tary policy variables. We test the null hypothesis that the
lagged value of the endogenous variable (either monetary
policy or stock market liquidity) does not Granger-cause the
dependent variable.
Table 2 reports the x2 statistics and p-values of pairwise
Granger causality tests between endogenous VAR variables.
Panel (A) of Table 2 depicts that the monetary policy varia-
bles (CMR and RM) are informative in predicting stock mar-
ket liquidity. We find the change in CMR significantly
Granger causes trading activity, price impact, and transac-
tion cost measures (TV, TPI, and HLS). There is a unidirec-
tional causality observed from RM to TV and ILLIQ.
Interestingly, Panel (B) of Table 2 documents very little evi-
dence of causality from stock market liquidity to monetary pol-
icy. There is a unidirectional causal relationship between
monetary policy and stock market liquidity. We do not observe
any bidirectional causality. Overall, the empirical results sup-
port the notion that monetary policy plays an essential role in
determining the stock market liquidity (Chowdhury et al.,
2018; Ferna
ndez-Amador et al., 2013). Our results, however,
do not support Chowdhury et al’s (2018) findings of reverse cau-
sality from Amihud's (2002) illiquidity measure (ILLIQ) and TPI
measure to monetary policy variables (CMR, RM).
To understand the dynamic interaction among the varia-
bles in the model, subsequently we conducted IRF analysis.
The IRF is meant to elucidate the impact of unit standard
deviation innovation to one of the variables on current and
future values of other endogenous variables. We use the
standard Cholesky decomposition method keeping in mind
the existence of a high correlation between monetary policy
innovations. We primarily aim at tracing the dynamic reac-
tion of stock market liquidity for every unit standard devia-
tion innovation in the monetary policy variables. The
response of stock market liquidity to unit standard devia-
tion change in call-money rate (CMR), traced forward
throughout 24 months is shown in Figure S1 in the supple-
mentary material accompanying the online article.
 ARTICLE IN PRESS
10
Table 2 VAR Granger-causality tests for the entire sample
Panel (A): Granger causality tests: Monetary policy and stock market liquidity
(H0 : Monetary policy does not Granger cause stock market (il)liquidity)
Variables TV TR
CMR 4.11 {0.05} 1.10 {0.35}
RM 4.74 {0.02} 0.80 {0.37}
Panel (B): Granger causality tests: Liquidity variables and monetary policy
(H0 : Stock market (il)liquidity does not Granger cause monetary policy)
Variables CMR
TV 0.22 {0.64}
TR 0.15 {0.87}
ILLIQ 0.90 {0.35}
TPI 0.12 {0.84}
HLS 2.98 {0.09}
Note: This table presents x2 statistics of pair wise Granger-causality tests between monetary policy and stock market liquidity measures.
Liquidity variables i.e., traded value (TV), turnover ratio (TR), illiquidity ratio (ILLIQ), turnover price impact (TPI), high-low spread (HLS);
monetary policy variables i.e., call money rate (CMR), reserve money growth rate (RM). Figures in the curly bracket represent p-values.
Sample period consists of 156 monthly observations from April 2002 till March 2015.
Similarly, Figure S2 shows a positive influence of money
supply (RM) on stock market liquidity.
The IRF analysis (Figs. S1 and S2) show that an expansion-
ary monetary policy, which is characterised by lowering
interest rate or increasing the money supply, strengthens
aggregate market liquidity. Also, tightening of monetary pol-
icy is associated with a decline in aggregated stock market
liquidity. Our findings from IRFs are consistent with those of
Goyenko and Ukhov (2009), Ferna
ndez-Amador et al. (2013),
and Chowdhury et al. (2018). Furthermore, we carry out var-
iance decomposition to know the percentage of stock mar-
ket liquidity explained by macroeconomic variables,
particularly monetary policy. For brevity, we have reported
the variance decomposition of liquidity variables only.
Tables 3 and 4 report the variance decomposition of
liquidity variables for call-money rate (CMR) and reserve-
money growth rate (RM), respectively. From this analysis,
we draw the following inferences. We find little evidence of
the immediate effect of monetary policy on stock market
liquidity; however, the impact is prominent after six months.
This implies that the monetary policy influences liquidity
with some lag. The lag effect of monetary policy on market
liquidity may be due to the fact that effect of monetary
transmission channel in India appears to be effective with an
average lag of 2-4 quarters (Acharya, 2017; Patel et al.,
2014). Our broad results are also consistent with
Chowdhury et al. (2018). We derive a mix of evidence of
monetary policy explaining stock market liquidity in compar-
ison to other macroeconomic and firm-specific variables.
While the influence of monetary policy is prominent in most
cases, results also reveal that other control variables like FII
and IP also explain stock market liquidity.
Our broad results in this study reveal that monetary pol-
icy changes significantly Granger-cause stock market liquid-
ity. However, one may still argue that that these findings are
very broad and at times these results may not be sacrosanct
across the timeline. In order to address this concern, in our
Please cite this article in press as: B. Debata et al., Monetary policy and liquidity: Does investor sentiment matter?, IIMB Management Review (2021), https://
doi.org/10.1016/j.iimb.2021.07.001
B. Debata et al.
ILLIQ TPI HLS
1.33 {0.20} 10.45 {0.00} 9.59 {0.00}
4.01 {0.05} 2.25 {0.13} 1.96 {0.31}
RM
0.89 {0.35}
0.31 {0.58}
2.37 {0.12}
0.53 {0.47}
0.88 {0.36}
subsequent analysis we carry out a robustness test of the
time-series relationship. We further divide our sample into
two parts, i.e., April 2002-July 2007, and August 2007-March
2015. The rationale behind this approach is to explore the
nexus between monetary policy and financial market liquid-
ity during financial crisis periods. Even though there is no
structural break in our sample period, for the robustness
test, we consider global financial crisis period (2007-08) as
an important economic event to split our sample into pre-
and post-crisis period. It is worthwhile to mention that
related literature adopts the crisis period definition in many
ways i.e., ad-hoc (based on the economic event only), statis-
tical approach, and both (Dimitriou & Kenourgios, 2013).
Consistent with the ad-hoc approach used by Dimitriou and
Kenourgios (2013), Hudsona and Green (2015),
Debata et al., (2018) our approach to crisis period identifica-
tion is based on major economic and financial events during
the 2007-2008 financial crisis. The first part of the sample
(April 2002-July 2007) has not witnessed any major market
crisis event. On the other hand, the second part of the sample
(August 2007-March 2015) has embraced a series of crises,
such as the global financial crisis (2008), European sovereign
debt crisis (2010), and the Russian financial crisis (2014). Our
motivation for the division of the data period is based on the
occurrences of financial market crises. Table 5 reports the
Granger-causality tests between stock market liquidity and
monetary policy considering the two sub-samples.
We ran the same set of VAR models, Granger-causality
test, and IRFs to examine the consistency of our results. For
the robustness test, we also carry out IRF analysis to trace
the reaction of stock market liquidity variables to unit stan-
dard deviation innovation in monetary policy variables in
both the sub-sample periods. IRF results are reported in
Figures S3 and S4 in the supplementary material accom-
panying the online version of the article.
Consistent with our hypothesis, both the figures reveal
that a positive shock to monetary policy significantly affects
 ARTICLE IN PRESS
Monetary policy, investor sentiment and liquidity 11

Table 3 Variance decomposition of liquidity variables for call-money rate (CMR)

Panel (A): Variance decomposition of Traded Value (TV)

Period Standard Error TV IP IR FII CMR STDV RET
1 0.0021 93.50 1.00 0.00 0.00 1.00 2.00 2.50
6 0.0009 69.00 3.20 2.00 7.60 11.70 3.00 3.50
12 0.0003 55.00 4.50 2.20 10.50 19.00 4.90 3.90

Panel (B): Variance decomposition of Turnover Ratio (TR)

Period Standard Error TR IP IR FII CMR STDV RET
1 0.00002 89.00 2.00 0.50 1.50 1.80 2.70 2.50
6 0.0001 65.00 5.90 1.50 5.80 14.60 3.90 3.30
12 0.00001 50.50 6.90 1.50 10.20 22.20 4.20 4.50

Panel (C): Variance decomposition of Amihud’s (2002) Illiquidity Ratio (IILIQ)

Period Standard Error ILLIQ IP IR FII CMR STDV RET
1 0.00002 86.00 2.20 0.70 2.50 1.90 2.80 3.90
6 0.0032 61.90 4.20 2.50 9.10 15.20 3.00 4.10
12 0.000001 53.00 4.50 1.50 9.50 24.00 3.50 4.00

Panel (D): Variance decomposition of Turnover Price Impact (TPI)

Period Standard Error TPI IP IR FII CMR STDV RET
1 0.00001 90.50 2.70 0.50 1.50 1.20 1.50 2.10
6 0.00009 62.00 3.80 1.80 7.90 18.00 2.50 4.00
12 0.00069 49.70 4.50 2.40 11.20 23.90 4.00 4.30

Panel (E): Variance decomposition of High-Low Spread (HLS)

Period Standard Error HLS IP IR FII CMR STDV RET
1 0.000006 88.00 1.80 0.50 2.70 1.30 2.00 3.70
6 0.00001 64.70 4.00 3.50 6.50 15.00 3.40 2.90
12 0.00004 57.00 5.10 2.00 9.00 19.00 4.20 3.70
Note: This table presents the variance decomposition of all liquidity variables i.e., traded value (TV), turnover ratio (TR), illiquidity ratio
(ILLIQ), turnover price impact (TPI), high-low spread (HLS) for call money rate (CMR). Sample period consists of 156 monthly observations
from April 2002 till March 2015.

aggregate market liquidity. As evident, the innovation in
reserve money leads to a rise in traded value and turnover
ratio, and decreases illiquidity measures. Similarly, the hike
in interest rate leads to a decline in trading activity and
increases the bid-ask spread. We have carried out the vari-
ance decomposition analysis across sub-samples and found
that the findings are consistent with our whole sample peri-
ods. (On account of the space constraint, we have not
reported the variance decomposition tables.) Overall, the
estimated results from sub-samples are consistent with the
entire sample period.
Monetary policy and individual stock liquidity: Panel
estimation results
This subsection elucidates the impact of monetary policy on
individual stock liquidity using panel fixed-effect estimation
(Equation 4). To carry out our analysis in panel framework,
we follow the standard procedure to choose a suitable
panel-data model by employing LR, LM, and Hausman tests.
We have also taken care of the stationarity of variables used
in the model. To check stationarity, we carry out Levin, Lin,
and Chu (2002) and Pesaran (2007) unit root tests. Due to
space constraint, we have not reported the unit root test
results. We estimate Equation (4) for the five liquidity meas-
ures and two monetary policy variables, which constitute a
total of 10 estimations. Table 6 reports the panel estimation
results for the call-money rate (CMR) and reserve-money
growth rate (RM). Panel (A) of Table 6 focusses on CMR and
(il) liquidity relationship. Panel (B) of Table 6 incorporates
estimation results for RM and (il) liquidity.
Reported results in Table 6 reveal that the CMR adversely
affects the trading activity and boosts illiquidity of stocks.
We also find a positive and significant effect of CMR on illi-
quidity measures. The results support our hypothesis that
the tightening of monetary policy adversely affects stock
liquidity. Most of the signs are in line with our hypothesis

Please cite this article in press as: B. Debata et al., Monetary policy and liquidity: Does investor sentiment matter?, IIMB Management Review (2021), https://
doi.org/10.1016/j.iimb.2021.07.001
 ARTICLE IN PRESS
12 B. Debata et al.

Table 4 Variance decomposition of liquidity variables for reserve-money growth rate (RM)

Panel (A): Variance decomposition of Traded Value (TV)

Period Standard Error TV IP IR FII RM STDV RET
1 0.0005 97.00 0.00 0.00 0.00 1.00 1.00 1.00
6 0.0006 71.50 2.30 2.50 7.00 12.20 2.00 2.50
12 0.0006 59.20 4.50 0.30 10.00 20.8 3.20 2.00

Panel (B): Variance decomposition of Turnover Ratio (TR)

Period Standard Error TO IP IR FII RM STDV RET
1 0.004 91.00 2.00 0.00 1.00 1.00 2.50 2.50
6 0.0001 63.50 3.3 1.50 5.50 10.70 2.50 3.00
12 0.001 50.50 4.0 1.50 11.00 26.50 3.00 4.50

Panel (C): Variance decomposition of Amihud’s (2002) Illiquidity Ratio (IILIQ)

Period Standard Error ILLIQ IP IR FII RM STDV RET
1 0.0001 86.50 3.00 0.50 2.50 2.50 2.80 2.20
6 0.0023 59.50 4.50 3.50 9.50 16.50 3.00 3.50
12 0.0004 51.00 5.50 1.50 10.50 24.00 3.50 4.00

Panel (D): Variance decomposition of Turnover Price Impact (TPI)

Period Standard Error TPI IP IR FII RM STDV RET
1 0.00003 89.00 3.00 0.50 1.50 2.00 1.50 2.50
6 0.00004 61.90 4.00 1.50 8.00 18.10 3.00 3.50
12 0.00056 52.00 4.5 1.50 11.00 23.00 4.00 4.00

Panel (E): Variance decomposition of High-Low Spread (HLS)

Period Standard Error HLS IP IR FII RM STDV RET
1 0.00001 90.00 1.00 0.50 2.50 1.50 2.00 2.50
6 0.00002 64.70 4.00 3.50 6.50 15.00 3.40 2.90
12 0.00001 52.00 3.50 2.00 12.00 24.00 3.40 3.10
Note: This table presents the variance decomposition of all liquidity variables i.e., traded value (TV), turnover ratio (TR), illiquidity ratio
(ILLIQ), turnover price impact (TPI), high-low spread (HLS) for reserve money growth rate (RM). Sample period consists of 156 monthly
observations from April 2002 till March 2015.

and are significant. When the interest rate increases, the
trading activity of stocks tends to decrease substantially.
One of the plausible reasons could be the constraint in fund-
ing liquidity during the higher interest rate regime. In a pure
order-driven market (such as India), market participants
provide liquidity through interaction with each other and
their ability to do so depends on how cheaply they can
finance their assets. A higher interest rate increases the cost
of funding available to the investors making them reluctant
to trade in the market. Thus, the trading activity of stocks
reduces significantly and causes illiquidity. These findings
are consistent with Soderberg (2008), Goyenko and
Ukhov (2009), Fernandez-Amador et al. (2013), and
Chowdhury et al. (2018). Apart from empirical evidence, our
findings can also be substantiated with the real-world obser-
vations made by popular financial press in India. For
instance, in a recent financial press coverage before RBI’s
Monetary Policy Committee meeting an analyst observed
that “equity investors expect RBI to remain hawkish because
equity investors in India have been increasing the amount of
cash they’re holding ahead of the central bank’s interest-
rate decision. That’s because they’re expecting an increase
in interest rate or borrowing costs and want to have plenty
of money to deploy when it’s time to invest again” (Chakra-
borty, 2018). The observation emphasises the importance of
liquidity funding constraint due to an expectation of interest
rate hike. Our results in Panel (B) of Table 6 further corrobo-
rate the implication of reserve-money growth rate (RM) on
firm specific (il)liquidity measures. Overall, our results con-
firm that an expansionary (contractionary) monetary policy
increases (decreases) the firm specific liquidity. Looking at
the firm specific control variables we observe that though
most related literature (Amihud & Mendelson, 1989;
Brennan et al., 1998; Datar et al., 1998) documents an
inverse relationship between stock return (RET) and liquid-
ity, we derive a positive relationship between them. One
possible reason could be the low degree of integration of
emerging equity markets with the global economy (Bekaert

Please cite this article in press as: B. Debata et al., Monetary policy and liquidity: Does investor sentiment matter?, IIMB Management Review (2021), https://
doi.org/10.1016/j.iimb.2021.07.001
 ARTICLE IN PRESS
Monetary policy, investor sentiment and liquidity 13

Table 5 Sub-sample period analysis: VAR Granger-causality test

Panel (A): Granger causality tests: Monetary policy and stock market liquidity (April 2002 to July 2007)
(H0 : Monetary policy does not Granger cause stock market liquidity)
TV TR ILLIQ TPI HLS
CMR 1.67 {0.61} 5.74 {0.05} 1.26 {0.35} 6.88 {0.04} 13.87 {0.01}
RM 11.54 {0.01} 9.41 {0.02} 1.89 {0.59} 2.44 {0.11} 11.89 {0.01}

Panel (B): Granger causality tests: Monetary policy and stock market liquidity (August 2007 to March 2015)
(H0 : Monetary policy does not Granger cause stock market liquidity)
TV TR ILLIQ TPI HLS
CMR 12.49 {0.01} 11.28 {0.01} 1.98 {0.17} 8.03 {0.03} 8.10 {0.03}
RM 8.71 {0.03} 2.63 {0.23} 7.31 {0.04} 1.99 {0.21} 7.39 {0.03}
Note: This table presents x2 statistics of pair wise Granger causality tests between monetary policy and stock market liquidity variables.
Figures in the curly brackets show p-values. Liquidity variables i.e., traded value (TV), turnover ratio (TR), illiquidity ratio (ILLIQ), turn-
over price impact (TPI), high-low spread (HLS); monetary policy variables i.e., call money rate (CMR), reserve money growth rate (RM).
Sample period for Panel A consists of monthly observations from April 2002 till July 2007 i.e., pre-crisis period. The sample period for Panel
B spans from August 2007 to March 2015 i.e., crisis period.

& Harvey, 1997; Jun et al., 2003). Besides, we document a
negative impact of volatility (STDV) on stock liquidity. As
evident from the study of Wang, Yau, and Baptiste (1997)
and Wang and Yau (2000) higher volatility results in a higher
spread and lower liquidity. Also, higher volatility imposes a
constraint on the funding liquidity of financial intermediar-
ies due to higher expected return, which subsequently
restricts liquidity supply, and it becomes costly for traders
to finance their assets (Brunnermeier & Pedersen, 2009).
In order to access the robustness of our results across the
subsamples, we further segregate sample period into two
sub-sample periods i.e., non-crisis period (April 2002-July
2007) and crisis period (August 2007- March 2015)7. From the
sub-samples analyses we find that irrespective of the choice
of sample period, there exists a positive (negative) effect of
expansionary (contractionary) monetary policy on stock
market liquidity. However, the effect of monetary policy on
all the aspects of liquidity i.e., trading activity (TV, TR),
price impact (ILLIQ, TPI), and transaction cost (HLS) is more
prominent during the time of crises. Most of the signs of the
control variables are in line with the theoretical argument
and consistent with our results in Table 6 for the full sample.
The empirical results of the sub-sample analyses are
shared in Table S3 in the supplementary material accom-
panying the online article.
Monetary policy, liquidity and investor
sentiment
In this section we carry out a test to examine the impact of
monetary policy on stock market liquidity during high and
low sentiment periods. In recent years, a behavioural expla-
nation concerning noise trading and sentiment induced trad-
ing behaviour of market participants has emerged as a
possible determinant of stock market liquidity (Baker &
7
Our emphasis on the two subsamples is mentioned in detail in note
number 6. Furthermore, we are thankful to the anonymous
reviewer(s) to motivate us on this analysis.
Stein, 2004; Debata et al., 2018; Huberman & Halka, 2001;
Liu, 2015). Our test accounts for possible asymmetries in the
effect of monetary policy on stock market liquidity in differ-
ent market regimes i.e., high sentiment (bullish) versus low
sentiment (bearish) periods.
The VAR Granger-causality test results between monetary
policy and liquidity across high and low sentiment periods
are reported in Table 7. Panel (A) and (B) of Table 7 report
the Granger-causality test results for high and low sentiment
periods respectively. The estimated results reveal that the
relationship between monetary policy and stock market
liquidity is evident across both sentiment periods. However,
the reported results in Panel (A) of Table 7 suggest that dur-
ing high sentiment periods the relationship between mone-
tary policy variables (CMR and RM) and liquidity proxies (TV,
TR, ILLIQ, TPI, and HLS) is more persistent in terms of the
statistical significance as compared to low sentiment peri-
ods. However, the VAR Granger-causality test results only
show us the relationship i.e., the direction of the causality
and not the magnitude of the relationship.
We have also carried out a variance decomposition analy-
sis for both the sub-periods and found that the results are
almost similar with our whole period analysis. For brevity,
we have not reported the results. Figure S5 and Figure S6
(Figure S7 and Figure S8) (appearing in the supplementary
material accompanying the online version of the article)
represent the IRF analysis during high (low) sentiment
period. Figure S5 and Figure S6 (Figure S7 and Figure S8)
show the response of stock market liquidity to unit stan-
dard deviation innovation in the call money rate (CMR)
and reserve money growth rate (RM) respectively during
high (low) sentiment period.
Consistent with our hypothesis, the IRF results during high
and low sentiment periods show a distinctive pattern of
monetary policy and stock market liquidity relationship.
However, the results in Figure S5 and Figure S6 (i.e., during
high sentiment period) resemble Figures S1 and Figure S2 (i.
e., whole sample IRF analysis). Our reported results in
Table 7, and subsequent IRF analysis, suggest that the mone-
tary policy and stock market liquidity relationship is more

Please cite this article in press as: B. Debata et al., Monetary policy and liquidity: Does investor sentiment matter?, IIMB Management Review (2021), https://
doi.org/10.1016/j.iimb.2021.07.001
 14
Table 6 Panel estimations: Monetary policy and firm specific liquidity measures

Variables Panel (A): Call-money rate (CMR) Panel (B): Reserve-money growth rate (RM)
TV TR ILLIQ TPI HLS TV TR ILLIQ TPI HLS
LIQ jti 0.7082*** 0.8480*** 0.1626*** 0.019 0.8562*** 0.7095*** 0.8504*** 0.1632** 0.0979*** 0.8559***
(125.56) (92.78) (19.36) (0.78) (56.10) (128.30) (83.00) (3.03) (9.28) (156.00)
CMRti -0.0715*** -0.0555*** 0.2176** 0.0012* 0.0005
(-19.30) (-11.48) (3.10) (2.99) (0.73)
RMti 0.0141*** 0.0036*** -0.0430*** 0.0010 -0.0001***
(23.69) (19.60) (-8.05) (0.89) (-10.00)
RETjti 0.0407 0.0178*** 0.1453 -0.0013*** 0.0001 -0.0426*** 0.0193*** -0.0307*** -0.0014 0.0000
(0.97) (17.37) (1.03) (-16.23) (0.68) (-7.17) (6.23) (-11.12) (-1.15) (0.51)
STDVjti -0.0159*** 0.1047*** -0.0753 0.0222** 0.0001*** -0.0194 -0.1074*** 0.0842 0.0222*** -0.0006***
(-8.01) (13.20) (-0.97) (3.23) (38.00) (-0.74) (-12.03) (0.99) (8.78) (-7.06)
SZjti -0.0005*** -0.0002*** 0.0002*** 0.0001 -0.0010* 0.0005*** 0.0002*** -0.0002 0.0001 -0.0009**

ARTICLE IN PRESS
(-7.30) (11.89) (12.50) (0.91) (-2.70) (5.57) (9.98) (-0.88) (0.83) (-2.96)
IPti -0.0034*** 0.0074 -0.0184*** 0.0000*** 0.0001 -0.0044** 0.0118 0.0160 -0.0009*** -0.0002*
(-12.04) (1.50) (-11.01) (20.00) (0.69) (-17.58) (1.35) (0.96) (-9.28) (-1.89)
IRti 0.9610*** 0.003 -0.0199* -0.0004*** -0.0061*** 0.0063*** 0.0067*** -0.0180 -0.0006** 0.0000***
(8.75) (0.77) (-1.92) (-10.50) (-5.23) (8.81) (7.82) (-1.45) (-2.18) (11.70)
FIIti 0.0056*** 0.0036*** -0.0181** 0.0000 0.0000 -0.0009 -0.0006*** 0.0039*** -0.0009*** -0.0002
(17.89) (20.91) (-3.19) (0.64) (0.88) (-1.12) (-10.11) (6.64) (-5.40) (-1.03)
INDEXti 0.0048*** 0.0006*** -0.0006 -0.0036*** -0.0034 0.0004*** 0.0005*** -0.0041 -0.0003*** 0.0000
(23.50) (18.50) (-1.13) (-21.03) (-1.43) (11.90) (8.02) (-0.78) (-8.33) (1.20)
LR Test [x2(509)] 562 {0.00} 612 {0.00} 591{0.00} 466{0.00} 761 {0.00} 662 {0.00} 562 {0.00} 591 {0.00} 496 {0.00} 717 {0.00}
LM Test [x2(1)] 98 {0.00} 112 {0.00} 79{0.00} 135{0.00} 229 {0.00} 198 {0.00} 102 {0.00} 179 {0.00} 153 {0.00} 129 {0.00}
Hausman Test [x2(9)] 908 {0.00} 1002 {0.00} 890{0.00} 350{0.00} 1229 {0.00} 981 {0.00} 991 {0.00} 1189 {0.00} 1350 {0.00} 766 {0.00}
D-W Statistics 2.11 2.17 2.10 2.19 2.20 2.01 2.11 2.09 2.19 2.14
Adj. R2 0.81 0.35 0.71 0.40 0.75 0.7 0.92 0.29 0.17 0.74
F-statistics 191 202 290 199 210 199 102 220 256 230
F(509, 79290) {0.00} {0.00} {0.00} {0.00} {0.00} {0.00} {0.00} {0.00} {0.00} {0.00}
Note: This table reports the panel fixed effect model estimations of Equation (4) when monetary policy is approximated by call money rate (CMR) and reserve money growth rate (RM). Panel
(A) focusses on CMR and Panel (B) incorporates estimation results for RM. Five liquidity variables are traded value (TV), turnover ratio (TR), illiquidity ratio (ILLIQ), turnover price impact
(TPI), high-low spread (HLS); macroeconomic control variables i.e., industrial production growth rate (IP), inflation rate (IR), the net funds flow from foreign institutional investors (FII), and
return from CNX Nifty 50 index (INDEX). Firm specific control variables are firm size (SZ), monthly return (RET), standard deviation of return (STDV). Detailed description of variables are avail-
able in the section on variables and descriptive statistics. Sample period spans from April 2002 to March 2015. Likelihood Ratio (LR) test (Gourieroux et al., 1982) carried out to identify the
existence of individual firm specific effects in the data set. Lagrange multiplier (LM) test (Breusch & Pagan, 1980) has been used to test the acceptability of panel data models over the classi-
cal regression models. The Hausman (1978) specification test is performed on each system to determine which estimation method is most appropriate. The values in curly brackets represent
p-values. t-values are given in the parenthesis. *, ** and *** denote 10%, 5% and 1% significance level, respectively.

B. Debata et al.
 ARTICLE IN PRESS
Monetary policy, investor sentiment and liquidity 15

Table 7 VAR Granger-causality test: High and low investor sentiment period

Panel (A): Granger causality tests: Monetary policy and stock market liquidity (High sentiment period)
(H0 : Monetary policy does not Granger cause stock market (il)liquidity)
Variables TV TR ILLIQ TPI HLS
CMR 7.11** {0.02} 6.14** {0.04} 1.15 {0.75} 9.33***{0.00} 12.23***{0.00}
RM 10.33*** {0.00} 2.44 {0.22} 9.27***{0.00} 5.35** {0.05} 11.00***{0.00}

Panel (B): Granger causality tests: Monetary policy and stock market liquidity (Low sentiment period)
(H0 : Monetary policy does not Granger cause stock market (il)liquidity)
Variables TV TR ILLIQ TPI HLS
CMR 7.37** {0.02} 1.18 {0.77} 4.15 {0.08} 2.44 {0.12} 5.45** {0.05}
RM 11.09*** {0.00} 4.64 {0.06} 2.31 {0.13} 1.44 {0.54} 6.78** {0.03}
Note: This table presents x2 statistics of pair wise Granger causality tests between monetary policy and stock market liquidity variables
during high and low sentiment period. Liquidity variables are traded value (TV), turnover ratio (TR), illiquidity ratio (ILLIQ), turnover price
impact (TPI), high-low spread (HLS). Monetary policy variables are call money rate (CMR), and reserve money growth rate (RM). Investor
sentiment (SENT) is measured following the top-down approach of Baker and Wurgler (2006) sentiment index construction. The high (low)
sentiment period is characterised as the periods in which the sentiment values are greater (lesser) than the median sentiment value. Sam-
ple period for Panel (A) and (B) represent the higher and lower investor sentiment periods estimation results respectively. Figures in the
curly brackets show p-values. ***, **,* indicate significance at 1%, 5% and 10% level respectively.

prominent during low sentiment periods (Figs. S5, S6) as
compared to the high sentiment periods (Figs. S7, S8).
In order to further investigate the relationship between
monetary policy and stock market liquidity during high and
low sentiment periods, we estimate the following time
series regression for high and low sentiment periods:
LIQt ¼ ct þ a1 MonPolicyt1 þ a2 IPt1 þ a3 IRt1
þ a4 FIIt1 þ a5 INDEXt1 þ ejt
where LIQ represents the five liquidity proxies TV, TR, ILLIQ,
TPI, HLS. MonPolicy consists of two variables representing
the monetary policy environment in terms of call money
rate (CMR) and reserve money growth rate (RM). IP, IR, FII,
and INDEX are the control variables. We estimate Equa-
tion (5) twice i.e., high and low investor sentiment periods.
If investor sentiment plays an important role in transmitting
monetary policy effects on stock market liquidity then we
expect a statistical and economic significance of a1 during
high sentiment periods. We use OLS method and Newey and
West’s (1987) robust standard errors to estimate Equa-
tion (5). Table 8 reports the estimated results of Equa-
tion (5). Panel (A) and Panel (B) of Table 8 show the results
during high and low investor sentiment periods respectively.
Reported results in Panel (A) reveal that during high senti-
ment periods the expansionary monetary policy has a posi-
tive effect on stock market liquidity. However, in Panel (B)
though the sign of monetary policy variables is consistent
with the theoretical argument, the statistical significance is
much better and more prominent. The estimation results
further corroborate our hypothesis that investor sentiment
plays an important role in transmitting monetary policy
effects on stock market liquidity (Kurov, 2010; Lutz, 2015).
In further analysis, we examine the possible asymmetries
in the effects of monetary policy on firm level stock market
liquidity in different market regimes i.e., high sentiment
versus low sentiment periods. Our motivation in this regard
closely follows the hard to value and difficult to arbitrage
argument of Baker and Wurgler (2006). Baker and Bur-
gler (2006) suggest that investor sentiment predicts stock
returns in the cross-section, and certain category of stocks
(hard to value and difficult to arbitrage) are more sensitive
towards the sentiment effect. This raises the question
whether the investor sentiment influence on the monetary
policy and aggregate stock market liquidity will be consis-
tent for firm level liquidity. In order to test this hypothesis,
ð5Þ
we try to estimate our firm level panel estimation (Equa-
tion 4) for the firm level liquidity. Consistent with the time
series approach we estimate our panel estimation model
(Equation 4) for high sentiment period and low sentiment
period. As our objective is to examine the implication of
monetary policy on liquidity during different market senti-
ment environments and not to view the interaction of senti-
ment with monetary policy, we have not used the
interaction effect of sentiment dummy variable with mone-
tary policy. Table 9 reports the panel estimation result
(Equation 4) during high and low sentiment period. The
dependent variable is the firm specific liquidity proxies (TV,
TR,ILLIQ,TPI,HLS), and independent variable are lag values
of liquidity proxies, monetary policy variables (CMR and
RM), macro-economic variables (IP, IR,FII), firm specific con-
trol variables (SZ, RET, STDV). Reported results in panel (A)
and (B) of Table 9 reveal that the effect of monetary policy
on firm specific liquidity is higher (weaker) during low (high)
sentiment periods. In other words, investor psychology plays a
significant role in the response of firm-specific liquidity to
monetary policy environment. The persistent sentiment effect
on liquidity is consistent with the idea of Liu (2015) and
Debata et al’s (2017) argument that investor sentiment mat-
ters for the liquidity effects in the financial market. Overall
results for other control variables are consistent with the full
sample analysis results. Consistent with the small size illiquid-
ity effect argument (Amihud, 2002) we observe a positive
(negative) sign of SZ for liquidity (illiquidity) proxies.

Please cite this article in press as: B. Debata et al., Monetary policy and liquidity: Does investor sentiment matter?, IIMB Management Review (2021), https://
doi.org/10.1016/j.iimb.2021.07.001
 ARTICLE IN PRESS
16 B. Debata et al.

Table 8 Monetary policy and stock market liquidity: High and low sentiment periods

Panel (A): Monetary policy and stock market liquidity: High-sentiment period
Call Money Rate (CMR) and Stock Market Liquidity Reserve Money Growth (RM) and Stock Market Liquidity
TV TR ILLIQ TPI HLS TV TR ILLIQ TPI HLS
CMRt1 -0.23*** -0.05 0.04** 0.01 0.33***
(-3.11) (-1.12) (2.10) (0.50) (2.55)
RMt1 0.001 0.03** -0.002 -0.08* -0.12***
(0.68) (2.17) (-0.40) (-1.78) (-5.44)
IPt1 0.035** 0.001 -0.02*** -0.01** -0.000 0.018* 0.038** -0.001 -0.002 -0.000
(2.33) (1.33) (-3.93) (-2.02) (-0.66) (1.85) (2.48) (-1.10) (-1.25) (-1.08)
IRt1 -0.005 -0.03 0.000 0.002*** 0.000 -0.08*** -0.001 0.02 0.011** 0.009*
(-0.30) (-1.60) (0.12) (2.85) (2.51) (-3.55) (-1.22) (1.40) (1.99) (1.73)
FIIt1 0.09** 0.004 -0.14*** -0.000 -0.001 0.06** 0.001 -0.04* -0.001 0.03*
(2.32) (1.22) (-3.77) (-0.43) (-1.14) (2.01) (1.00) (-1.75) (-1.18) (1.85)
INDEXt1 0.004** 0.000 -0.001* -0.03*** -0.000 0.001*** 0.000 -0.0041 -0.003** 0.000
(2.20) (1.50) (-1.90) (-9.10) (-1.12) (2.90) (1.02) (-0.78) (-2.33) (1.20)
Adj. R2 0.38 0.30 0.51 0.28 0.42 0.40 0.31 0.48 0.26 0.33

Panel (B): Monetary policy and stock market liquidity: Low-sentiment period
CMRt1 -0.08 -0.12** 0.09*** 0.001 0.40***
(-1.10) (-2.22) (3.71) (0.77) (4.25)
RMt1 0.22 0.35** -0.02 -0.07 -0.02
(1.68) (2.78) (-1.04) (-1.23) (-0.94)
IPt1 0.014* 0.02 -0.04** -0.001 -0.001 0.011 0.025** -0.008 -0.05* -0.001
(1.77) (1.18) (-2.19) (-0.65) (-0.99) (1.72) (2.18) (-0.66) (-1.81) (-0.33)
IRt1 -0.09* -0.001 0.11*** 0.001 0.05* -0.03* -0.02 0.016* 0.001 0.002
(-1.90) (-1.00) (3.78) (0.77) (1.74) (1.75) (-1.22) (1.69) (1.00) (1.55)
FIIt1 0.10*** 0.001 -0.11** -0.000 -0.08** 0.002 0.055* -0.000 -0.22*** 0.001
(3.15) (0.89) (-2.23) (-0.33) (-2.32) (0.99) (1.89) (-0.55) (-4.33) (1.15)
INDEXt1 0.002* 0.000 -0.04** -0.000 -0.005** 0.001 0.09*** -0.004* -0.000 -0.002*
(1.68) (0.44) (-2.23) (-1.12) (-2.20) (1.20) (4.28) (-1.98) (-0.77) (-1.84)
Adj. R2 0.32 0.29 0.39 0.24 0.31 0.36 0.32 0.38 0.21 0.34
Note: This table represents the time series estimation results (Equation 5) of the impact of monetary policy on stock market liquidity
across high and low sentiment periods. The dependent variables are liquidity variables i.e., traded value (TV), turnover ratio (TR), illiquid-
ity ratio (ILLIQ), turnover price impact (TPI), high-low spread (HLS). The monetary policy variables are CMR, RM. Control variables are IP,
IR, FII, INDEX. Investor sentiment (SENT) is measured consistent with Baker and Wurgler (2006). The high (low) sentiment period is charac-
terised as the periods in which the sentiment values are greater (lesser) than the median sentiment value. Detailed description of all vari-
ables are available in the section on variables and descriptive statistics. The t-statistics (reported in parentheses) have been corrected for
the effects of heteroscedasticity and autocorrelation using the method of Newey and West (1987). ***, **,* indicate significance at 1%, 5%
and 10% level respectively.

Conclusion and implications
This paper examines the relationship between monetary pol-
icy and stock market liquidity in a pure order-driven emerg-
ing stock market. Our robustness test accounts for possible
asymmetries in the effects of monetary policy on stock mar-
ket liquidity in different market regimes i.e., optimistic
(high sentiment) versus pessimistic (low sentiment) market
environment. We employ five different liquidity measures to
capture several aspects of liquidity. Empirical analysis
approximates monetary policy by call-money rate and
twelve-month growth rate of reserve money. In order to
examine the relationship at aggregate market level, we
employ a multivariate VAR model, carry out VAR-Granger
causality test, impulse response analysis, and variance
decomposition. We investigate the relationship at individual
stock level by using panel fixed-effects model.
Results reveal that monetary policy changes significantly
Granger-cause stock market liquidity. Impulse response
analysis shows that an expansionary monetary policy (lower
interest rate or higher money supply) enhances stock market
liquidity. The variance decomposition reveals that a large
percentage of information pertinent to liquidity is attrib-
uted to monetary policy. Consistent with aggregate market
liquidity, the panel estimation results suggest that an expan-
sionary monetary policy significantly leads to an increase in
the individual stock liquidity. Overall, we document a strong
predictability of monetary policy on liquidity. Our findings
are consistent with Goyenko and Ukhov (2009), Ferna
ndez-
Amador et al. (2013) and Chowdhury et al. (2018). However,
the relationship between monetary policy and stock market
liquidity is stronger during low sentiment periods as com-
pared to high sentiment periods. Our findings lend support
to the argument that investor sentiment is an essential

Please cite this article in press as: B. Debata et al., Monetary policy and liquidity: Does investor sentiment matter?, IIMB Management Review (2021), https://
doi.org/10.1016/j.iimb.2021.07.001
 Monetary policy, investor sentiment and liquidity
Table 9 Monetary policy and individual stock liquidity: High and low sentiment periods

Monetary Policy (CMR) and Stock Market Liquidity Monetary Policy (RM) and Stock Market Liquidity
TV TR ILLIQ TPI HLS TV TR ILLIQ TPI HLS
Panel (A): Monetary Policy and Stock Market Liquidity: High-Sentiment period
LIQ jt1 0.95*** 0.72*** 0.0832*** 0.02** 0.06*** 0.80*** 0.65*** 0.04*** 0.06*** 0.09***
(180.50) (113.00) (5.55) (2.28) (59.00) (156.00) (101.00) (3.51) (3.39) (89.00)
CMRt1 -0.08 -0.05 0.22** 0.04 0.00
(1.24) (-1.12) (2.12) (0.77) (0.33)
RMt1 0.30** 0.28*** -0.02 -0.05 -0.01
(2.29) (3.85) (-1.10) (-1.28) (-0.56)
STDVjt1 -0.20** -0.05 0.07 0.28** 0.00 -0.36** -0.22** 0.11* 0.05 0.34**
(-2.20) (-1.03) (1.55) (2.14) (0.67) (-2.28) (-2.33) (1.66) (0.46) (2.25)
RETjt1 0.42*** 0.3*** -0.00 -0.3** -0.2** 0.5*** 0.00 -0.3** -0.01 -0.25***
(4.98) (3.10) (-0.66) (-2.20) (-1.84) (6.44) (0.59) (-2.31) (-1.01) (-3.11)

ARTICLE IN PRESS
SZjti 0.002*** 0.003*** -0.001 0.001 -0.009*** 0.001** 0.007*** -0.000* 0.000 -0.0001
(4.11) (4.55) (-0.94) (0.65) (-3.96) (2.15) (8.77) (-1.88) (0.66) (-1.06)
IPt1 0.17** 0.29** -0.02 -0.07 -0.01 0.23*** 0.20** -0.01 -0.00 -0.02
(2.05) (2.39) (-0.88) (-1.42) (-1.08) (2.58) (2.33) (-0.94) (-0.44) (-1.25)
IRt1 -0.00 -0.03 0.00 0.004 0.048* -0.02 -0.00 0.13** 0.00 0.05
(0.48) (-1.34) (0.68) (0.90) (1.88) (-1.28) (-0.77) (2.11) (0.78) (1.01)
FIIt1 0.10** 0.35*** -0.06* 0.00 -0.00 0.25*** 0.23*** -0.00 -0.00 0.05**
(2.33) (3.98) (-1.72) (0.66) (-0.35) (2.89) (2.78) (-0.74) (-0.51) (2.15)
INDEXti 0.008*** 0.004*** -0.000 -0.000 0.006** 0.000 0.005*** -0.000 -0.003*** 0.000
(12.40) (5.16) (-0.78) (-0.48) (2.20) (1.46) (4.55) (-0.71) (-4.33) (0.64)
LR Test [x2(509)] 228 320 {0.00} 298 {0.00} 310 {0.00} 368 312 {0.00} 208 {0.00} 333 456 {0.00} 527
{0.00} {0.00} {0.00} {0.00}
Hausman Test [x2(9)] 456 {0.00} 521 {0.00} 680 720 {0.00} 656 517 {0.00} 606 {0.00} 810 923 {0.00} 711
{0.00} {0.00} {0.00} {0.00}
D-W Stat 2.08 2.02 2.05 2.20 2.28 2.17 1.91 2.31 2.44 2.60
Adj. R2 0.62 0.75 0.56 0.49 0.68 0.68 0.72 0.60 0.51 0.75
F-statistics (509, 44580) 89 100 {0.00} 125 183 {0.00} 212 112 {0.00} 95 160 185 198
{0.00} {0.00} {0.00} {0.00} {0.00} {0.00} {0.00}

Panel (B): Monetary policy and stock market liquidity: Low-sentiment period
LIQ t1 0.7*** 0.55*** 0.07** 0.00* 0.16*** 0.57*** 0.61*** 0.01* 0.02 0.3***
(99.10) (122.00) (2.38) (1.68) (169.00) (88.00) (111.00) (1.71) (1.41) (178.00)
CMRt1 -0.38*** -0.14** 0.3*** 0.01 0.27***
(3.79) (-2.18) (3.54) (0.55) (4.41)

(continued)

17
 18
Table 9 (Continued)
Panel (B): Monetary policy and stock market liquidity: Low-sentiment period
RMt1 0.27** 0.3*** -0.02 -0.00 -0.34***
(2.30) (4.14) (-1.19) (-0.58) (-8.56)
STDVt1 -0.28*** -0.02 0.44*** 0.00 0.33*** -0.4*** -0.28** 0.01 0.00 0.20**
(-2.55) (-0.53) (4.22) (0.34) (3.23) (-5.10) (-2.40) (0.46) (0.11) (1.95)
RETt1 0.15* 0.41*** -0.05* -0.00 -0.00 0.30*** 0.11* -0.03 -0.01 -0.27***
(1.68) (4.45) (-1.69) (-0.20) (-0.14) (3.65) (1.79) (-1.31) (-0.49) (-3.22)
SZjti 0.003*** 0.000 -0.000 0.015*** -0.00 0.000 0.025*** -0.000 0.005* -0.000
(4.33) (1.51) (-0.90) (3.65) (-0.66) (1.35) (11.23) (-1.38) (1.86) (-0.56)
IPt1 0.04 0.10* -0.02 -0.00 -0.01 0.03 0.02 -0.18*** -0.00 -0.02
(1.01) (1.69) (-0.90) (-0.85) (-0.98) (1.18) (0.83) (-2.94) (-0.99) (-1.30)
IRt1 -0.11*** -0.09** 0.00 0.00 0.16*** -0.09** -0.00 0.1** 0.00 0.2***
(3.88) (-2.14) (0.80) (0.28) (4.11) (-2.01) (-0.77) (2.21) (0.58) (4.63)

ARTICLE IN PRESS
FIIt1 0.02 0.05 -0.10*** -0.00 -0.01 0.001 0.11* -0.00 -0.00 0.00
(0.83) (1.38) (-2.72) (0.5) (-0.89) (1.18) (1.66) (-0.75) (-0.33) (0.28)
INDEXti 0.000 0.008*** -0.000 -0.008** 0.005** 0.009*** 0.000 -0.000 -0.013*** 0.000
(1.47) (6.46) (-0.83) (-2.48) (2.13) (3.26) (1.33) (-0.71) (-6.11) (0.55)
LR Test [x2(509)] 311 298 {0.00} 189 400 {0.00} 288 410 {0.00} 236 {0.00} 311 422 {0.00} 626
{0.00} {0.00} {0.00} {0.00} {0.00}
Hausman Test [x2(9)] 519 {0.00} 410 {0.00} 580 789 {0.00} 823 489 {0.00} 589 {0.00} 855 {0.00} 787 {0.00} 929
{0.00} {0.00} {0.00}
D-W Stat 2.18 2.33 1.95 1.89 2.30 2.50 2.96 2.08 2.43 2.80
Adj. R2 0.71 0.62 0.66 0.53 0.74 0.60 0.68 0.55 0.49 0.64
F-statistics (509, 43820) 112 134 {0.00} 156 200 {0.00} 189 233 {0.00} 155 288 202 346
{0.00} {0.00} {0.00} {0.00} {0.00} {0.00} {0.00}
Note: This table presents the panel fixed effect model (Equation 4) estimation results across high and low sentiment period. The dependent variables are liquidity variables (TV, TR, ILLIQ, TPI,
HLS). The monetary policy variables are CMR, RM. Control variables are SZ, RET, STDV, IP, IR, FII, INDEX. Investor sentiment (SENT) is measured consistent with Baker and Wurgler (2006). High
(low) sentiment period is characterised as the periods in which the sentiment index values are greater (lesser) than the median sentiment value. Detailed description of variables are available
in the section on variables and descriptive statistics. Likelihood Ratio (LR) test is carried out to identify the existence of individual firm specific effects in the data set. Unreported Lagrange
Multiplier (LM) test has been used to test the acceptability of panel data models over the classical regression models. The Hausman test helps to determine which estimation method (fixed or
random) is most appropriate. Figures in curly brackets represent p-values. t-values are in the parenthesis. *, ** and *** denote 10%, 5% and 1% significance level respectively.

B. Debata et al.
 ARTICLE IN PRESS
Monetary policy, investor sentiment and liquidity
element for the determination of stock market liquidity
(Liu, 2015; Debata et al., 2018), and investor sentiment
plays a major role in the effect of monetary policy on stock
market (Kurov, 2010). Our empirical findings for the sub-
sample period robustness tests are consistent with the
results of the whole sample period.
Our results are relevant for practitioners and policy makers.
From the practitioners’ perspective our results corroborate the
fact that while incorporating monetary policy environment for
forecasting stock market liquidity it is imperative to access the
investor sentiment. Regulators and policymakers may consider
the relationship between market liquidity and monetary policy
as an important source of information for policy formulation
and implementation. However, the macroeconomic manage-
ment for enhancing stock market liquidity should consider the
sentiment environment in the market. To sum-up, since liquid-
ity contains strong and robust information about the condition
of the economy, adding financial channels like stock market
liquidity (Apergis et al., 2015; Chordia et al., 2000; Næs et al.,
2011) and investor sentiment environment (Debata et al.,
2018; Kurov, 2010; Liu, 2015; Lutz, 2015; Shen et al., 2017) to
macroeconomic modelling may be useful for policy makers.
Supplementary materials
Supplementary material associated with this article can be
found in the online version at doi:10.1016/j.iimb.2021.07.001.
References
Acharya, V.V. (2017). Monetary Transmission in India: Why is it
important and why hasn’t it worked well? Reserve Bank of India
Bulletin 71 (12), 7–16.
Amihud, Y. (2002). Illiquidity and stock returns: Cross-section and
time-series effects. Journal of Financial Markets 5, 31–56.
Amihud, Y., & Mendelson, H. (1986). Asset pricing and the bid-ask
spread. Journal of Financial Economics 17, 223–249.
Amihud, Y., & Mendelson, H. (1989). The effect of beta bid-ask
spread, residual risk, and size on stock returns. Journal of
Finance 44, 479–486.
Apergis, N., Artikis, P.G., & Kyriazis, D. (2015). Does stock market
liquidity explain real economic activity? New evidence from two
large European stock markets. Journal of International Financial
Markets, Institutions and Money 38, 42–64.
Bekaert, G., Harvey, C.R., & Lundblad, C. (2007). Liquidity and
expected returns: Lessons from emerging markets. Review of
Financial studies 20, 1783–1831.
Bekaert, G., & Harvey, C.R. (1997). Emerging equity market volatil-
ity. Journal of Financial Economics 43, 29–77.
Bekaert, G., & Harvey, C.R. (2003). Emerging market finance. Jour-
nal of Empirical Finance 10, 3–55.
Baker, M., & Wurgler, J. (2006). Investor sentiment and the cross-
section of stock returns. Journal of Finance 61 (4), 1645–1680.
Baker, M., & Stein, J.C. (2004). Market liquidity as a sentiment indi-
cator. Journal of Financial Markets 7 (3), 271–299.
Baker, H.K., & Nofsinger, J.R. (2002). Psychological biases of invest-
ors. Financial Services Review 11 (2), 97–116.
Barberis, N., Shleifer, A., & Vishny, R. (1998). A model of investor
sentiment. Journal of Financial Economics 49 (3), 307–343.
Brennan, M.J., Chordia, T., & Subrahmanyam, A. (1998). Alternative
factor specifications, security characteristics, and the cross-sec-
tion of expected stock returns. Journal of Financial Economics
49, 345–373.
Please cite this article in press as: B. Debata et al., Monetary policy and liquidity: Does investor sentiment matter?, IIMB Management Review (2021), https://
doi.org/10.1016/j.iimb.2021.07.001
19
Breusch, T.S., & Pagan, A.R. (1980). The Lagrange multiplier test
and its applications to model specification in econometrics.
Review of Economic Studies 47, 239–253.
Brockman, P., & Chung, D.Y. (2002). Commonality in liquidity: Evi-
dence from an order-driven market structure. Journal of Finan-
cial Research 4, 521–539.
Brunnermeier, M.K., & Pedersen, L.H. (2009). Market liquidity and
funding liquidity. Review of Financial Studies 22, 2201–2238.
Chakraborty, S. (2018). Monetary policy: Equity investors expect RBI
to remain hawkish, hike rate, business-standard, Available at:
www.business-standard.com/article/finance/monetary-policy-
equity-investors-expect-rbi-to-remain-hawkish-hike-rate-
118100500115_1.html (Accessed on 12-02-2019).
Chen, S.S. (2007). Does monetary policy have asymmetric effects on
stock returns? Journal of Money, Credit and Banking 39 (2-3),
667–688.
Chordia, T., Roll, R., & Subrahmanyam, A. (2000). Commonality in
liquidity. Journal of Financial Economics 56, 3–28.
Chordia, T., Sarkar, A., & Subrahmanyam, A. (2005). An empirical
analysis of stock and bond market liquidity. Review of Financial
Studies 18, 85–129.
Chowdhury, A., Uddin, M., & Anderson, K. (2018). Liquidity and
macroeconomic management in emerging markets. Emerging
Markets Review 34, 1–24.
Chu, X. (2015). Modelling impact of monetary policy on stock mar-
ket liquidity: A dynamic copula approach. Applied Economics
Letters 22, 820–824.
Copeland, T.E., & Galai, D. (1983). Information effects on the bid-
ask spread. Journal of Finance 5, 1457–1469.
Coulibaly, B. (2012). Monetary policy in emerging market econo-
mies: What lessons from the global financial crisis? International
Finance Discussion Paper No. 1042, Board of Governors of the
Federal Reserve System, Washington DC, United States.
Corwin, S.A., & Schultz, P. (2012). A simple way to estimate bid-ask
spread from daily high-low prices. Journal of Finance 67, 719–
759.
Dash, S.R. (2016). Does investor sentiment as conditioning informa-
tion help to explain stock returns behaviour? A test of alternative
asset pricing models. Review of Behavioral Finance 8 (2), 174–
198.
Datar, V.T., Naik, Y.N., & Radcliffe, R. (1998). Liquidity and stock
returns: An alternative test. Journal of Financial Markets 1, 203–
219.
Debata, B., Dash, S.R., & Mahakud, J. (2018). Investor sentiment
and emerging stock market liquidity. Finance Research Letters
26, 15–31.
De Long, J.B., Shleifer, A., Summers, L.H., &
Waldmann, R.J. (1990). Noise trader risk in financial markets.
Journal of political Economy 98 (4), 703–738.
Dimitriou, D., & Kenourgios, D. (2013). Financial crises and dynamic
linkages among international currencies. Journal of Interna-
tional Financial Markets, Institutions and Money 26, 319–332.
Dhal, S. (2000). Short-term interest rate and real economic activity.
RBI Occasional Paper 21 (1), 61–78.
Dickey, D., & Fuller, W. (1981). Likelihood ratio statistics for Autoregres-
sive time series with a unit root. Econometrica 49, 1057–1072.
Domowitz, I., Glen, J., & Madhavan, A. (2001). Liquidity, volatility
and equity trading costs across countries and over time. Interna-
tional Finance 4, 221–255.
Ehrmann, M., & Fratzscher, M. (2004). Taking stock: Monetary policy
transmission to equity markets. Journal of Money, Credit and
Banking 36, 719–737.
Eisfeldt, A.L. (2004). Endogenous liquidity in asset markets. Journal
of Finance 59, 1–30.
Ferna
ndez-Amador, O., Ga€chter, M., Larch, M., &
Perter, G. (2013). Does monetary policy determine stock mar-
ket liquidity? New evidence from the euro zone. Journal of
Empirical Finance 21, 54–68.
 ARTICLE IN PRESS
20
Florackis, C., Gregoriou, A., & Kostakis, A. (2011). Trading fre-
quency and asset pricing on the London stock exchange: Evi-
dence for a new price impact ratio. Journal of Banking and
Finance 35, 3335–3350.
Frankel, J. (2010). In Monetary policy in emerging markets, Hand-
book of Monetary Economics, ed by Friedman, B. and Woodford,
M. (Chapter 25, 1439-1520).
Friedman, M., & Schwartz, A.J. (1963). Money and business cycles.
The Review of Economics and Statistics 45, 32–64.
Garcia, G. (1989). The lender of last resort in the wake of the crash.
American Economic Review 79, 151–155.
Gourie
roux, C., Holly, A., & Monfort, A. (1982). Likelihood ratio
test, Wald test, and Kuhn-Tucker test in linear models with
inequality constraints on the regression parameters. Econometr-
ica 50, 63–80.
Goyenko, R.Y., Holden, C.W., & Trzcinka, C.A. (2009). Do liquidity
measures measure liquidity? Journal of Financial Economics 92,
153–181.
Goyenko, R.Y., & Ukhov, A.D. (2009). Stock and bond market liquid-
ity: A long-run empirical analysis. Journal of Financial and Quan-
titative Analysis 44, 189–212.
Granger, C.W.J. (1969). Investigating causal relations by econometric
models and cross-spectral methods. Econometrica 37, 424–438.
Hameed, A., Kang, W., & Viswanathan, S. (2010). Stock market
declines and liquidity. Journal of Finance 65, 257–293.
Hasbrouck, J. (2007). Empirical market microstructure: The institu-
tions, economics, and econometrics of security trading. Oxford
University Press, United States.
Hausman, J. (1978). Specification tests in econometrics. Econometr-
ica 46, 1251–1271.
Huberman, G., & Halka, D. (2001). Systematic liquidity. Journal of
Financial Research 24, 161–178.
Hudson, Y., & Green, C.J. (2015). Is investor sentiment contagious?
International sentiment and UK equity returns. Journal of Behav-
ioral and Experimental Finance 5, 46–59.
Inclan, C., & Tiao, G. (1994). Use of cumulative sums of squares for
retrospective detection of changes of variance. Journal of Amer-
ican Statistical Association 89, 913–923.
Jain-Chandra, S., & Unsal, D.F. (2014). The effectiveness of mone-
tary policy transmission under capital inflows: Evidence from
Asia. Borsa Istanbul Review 14, 96–103.
Jun, Sang-Gyung, Marathe, A., & Shawky, H.A. (2003). Liquidity and
stock returns in emerging equity markets. Emerging Markets
Review 4, 1–24.
Kamin, S.B., Turner, P., & Van’t dack, J. (1998). The transmission of
monetary policy in emerging market economies: An overview.
BIS Policy Papers 3, 5–64.
Kandil, M. (2014). On the effects of monetary policy shock in devel-
oping countries. Borsa Istanbul Review 14, 104–118.
Karolyi, G.A., Lee, K.H., & van Dijk, M.A. (2012). Understanding
commonality in liquidity around the world. Journal of Financial
Economics 105, 82–112.
King, R.G., & Plosser, C.I. (1984). Money, credit, and prices in a real
business cycle. American Economic Review 74, 363–380.
Klein, M.W., & Shambaugh, J.C. (2015). Rounding the corners of the
policy trilemma: Sources of monetary policy autonomy. Ameri-
can Economic Journal: Macroeconomics 7, 33–66.
Korajczyk, R.A., & Sadka, R. (2008). Pricing the commonality across
alternative measures of liquidity. Journal of Financial Economics
87, 45–72.
Kurov, A. (2010). Investor sentiment and the stock market’s
reaction to monetary policy. Journal of Banking & Finance 34
(1), 139–149.
Kwiatkowski, D., Phillips, P.C.B., Schmidt, P., & Shin, Y. (1992). Test-
ing the null hypothesis of stationarity against the alternative of a
unit root. Journal of Econometrics 54, 159–178.
Kyle, A.S. (1985). Continuous auctions and insider trading. Econo-
metrica 53, 1315–1335.
Please cite this article in press as: B. Debata et al., Monetary policy and liquidity: Does investor sentiment matter?, IIMB Management Review (2021), https://
doi.org/10.1016/j.iimb.2021.07.001
B. Debata et al.
Lesmond, D.A. (2005). Liquidity of emerging markets. Journal of
Financial Economics 77, 411–452.
Levin, A., Lin, C.F., & Chu, C.S.J. (2002). Unit root tests in panel
data: asymptotic and finite-sample properties. Journal of econo-
metrics 108 (1), 1–24.
Liu, S. (2015). Investor sentiment and stock market liquidity. Jour-
nal of Behavioral Finance 16 (1), 51–67.
Lo, A., & Mackinlay, C. (1990). Data snooping biases in tests of
financial asset pricing models. Review of Financial Studies 3,
431–467.
Lutz, C. (2015). The impact of conventional and unconventional
monetary policy on investor sentiment. Journal of Banking &
Finance 61, 89–105.
Ma, R., Anderson, H.D., & Marshall, B.R. (2016). International
stock market liquidity: A review. Managerial Finance 42, 118–
135.
McGettigan, D., Moriyama, K. N., Noah, N. J., Painchaud, F., Qu, H.,
& Steinberg, C. (2013). Monetary policy in emerging markets:
Taming the cycle. IMF Working Paper no. 13/96.
Mishra, A., & Mishra, V. (2012). Evaluating inflation targeting as a
monetary policy objective for India. Economic Modelling 29,
1053–1063.
Mishra, P., & Montiel, P. (2013). How effective is monetary transmis-
sion in low-income countries? A survey of the empirical evi-
dence. Economic Systems 37, 187–216.
Mohanty, M.S., & Turner, P. (2008). Monetary policy transmission in
emerging market economies: What is new? BIS Working Paper
35, 1–59.
Moulton, B.R. (1986). Random group effects and the precision of
regression estimates. Journal of Econometrics 32, 385–397.
Moulton, B.R. (1987). Diagnostics for group effect in regression
analysis. Journal of Business and Economic Statistics 5, 275–
282.
Næs, R., Skjeltorp, J.A., & Ødegaard, B.A. (2011). Stock market
liquidity and the business cycle. Journal of Finance 66, 139–176.
€
Nyborg, K.G., & Ostberg, P.P. (2014). Money and liquidity in financial
markets. Journal of Financial Economics 112, 30–52.
O’Hara, M. (1998). Market microstructure theory. Blackwell Publish-
ers, Cambridge, MA.

stor, L., & Stambaugh, R.F. (2003). Liquidity risk and expected
Pa
stock returns. Journal of Political Economy 111, 642–685.
Patel, U.R., Chinoy, S., Darbha, G., Ghate, C., Montiel, P.,
Mohanty, D., & Patra, M. (2014). Report of the expert committee
to revise and strengthen the monetary policy framework.
Reserve Bank of India, Mumbai.
Pesaran, H. (2007). A simple unit root test in the presence of cross-
section dependence. Journal of Applied Econometrics 22, 265–
312.
Phillips, P.C.B., & Perron, P. (1988). Testing for unit roots in time
series regression. Biometrika 75, 335–346.
Prabu, E.A., Bhattacharyya, I., & Ray, P. (2016). Is the stock market
impervious to monetary policy announcements: Evidence from
emerging India. International Review of Economics and Finance
46, 166–179.
Ray, P., & Prabu, E. A. (2013). Financial development and monetary
policy transmission across financial markets: What do daily data
tell for India? RBI working Paper No.DEPR/04/2013.
Sarr, A., and Lybek, T. (2002). Measuring Liquidity in Financial Mar-
kets. IMF Working Paper, WPS/02/232.
Shen, J., Yu, J., & Zhao, S. (2017). Investor sentiment and economic
forces. Journal of Monetary Economics 86, 1–21.
Shleifer, A., & Vishny, R. (1997). The limits of arbitrage. Journal of
Finance 52 (1), 35–55.
Shefrin, H., & Statman, M. (1985). The disposition to sell winners
too early and ride losers too long: theory and evidence. Journal
of Finance 40 (3), 777–790.
Shefrin, H. (2005). A behavioural approach to asset pricing. Elsevier
Academic Press, New York.
 ARTICLE IN PRESS
Monetary policy, investor sentiment and liquidity
Securities and Exchange Board of India, 2015. Handbook of statistics
on Indian securities market. Securities and Exchange Board of
India (SEBI), Mumbai, India.
Sims, C. (1980). Macroeconomics and reality. Econometrica 48, 1–48.
Soederberg, J. (2008). Do macroeconomic variables forecast changes in
liquidity? An out-of-sample study on the order-driven stock markets
in Scandinavia. Vaexjoe University, Sweden. Centre for Labour Mar-
ket Policy Research Working Paper Series-2009/10.
Statman, M., Thorley, S., & Vorkink, K. (2006). Investor overconfidence
and trading volume. Review of Financial Studies 19 (4), 1531–1565.
Tillmann, P. (2013). Capital inflows and asset prices: Evidence from
emerging Asia. Journal of Banking & Finance 37, 717–729.
Please cite this article in press as: B. Debata et al., Monetary policy and liquidity: Does investor sentiment matter?, IIMB Management Review (2021), https://
doi.org/10.1016/j.iimb.2021.07.001
21
Trichet, J.C. (2010). The great financial crisis: Lessons for financial
stability and monetary policy. colloquium in honour of Lucas
Papademos. European Central Bank, Germany.
Wang, G.H.K., & Yau, J. (2000). Trading volume bid-ask spread, and
price volatility in futures markets. Journal of Futures Markets
20, 943–970.
Wang, G.H.K., Yau, J., & Baptiste, T. (1997). Trading volume and
transaction cost in futures markets. Journal of Futures Markets
17, 757–780.
Wooldridge, J.M. (2002). Introductory Econometrics: A Modern
Approach. South-Western Educational Publishing, Manson, IA:
South-Western, Cengage Learning, USA.