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Monetary policy and liquidity: Does investor sentiment matter?

Byomakesh Debata , Saumya Ranjan Dash , Jitendra Mahakud

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DOI: https://doi.org/10.1016/j.iimb.2021.07.001
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To appear in: IIMB Management Review

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Monetary policy and liquidity: Does investor sentiment matter?

Byomakesh Debata 1 *, Saumya Ranjan Dash 2, Jitendra Mahakud 3

1
Department of Economics & Finance, BITS Pilani, Pilani, Rajasthan, India
2
Finance and Accounting, IIM Indore, Indore, Madhya Pradesh, India.
3
Department of Humanities and Social Sciences, IIT Kharagpur, Kharagpur, India

*
Corresponding author. Email: kingbyom@gmail.com; byomakesh.debata@pilani.bits-

pilani.ac.in, Phone no. +91-1596515658, +91-7585965885

Short title: Monetary policy, investor sentiment and liquidity

Abstract

We examine the relationship between monetary policy and liquidity effects at the macro (overall

market) and micro (individual stocks) levels, using data from the Indian stock market. We also

test the possible asymmetric effect of investor sentiment on the monetary policy -- liquidity

relationship. Results suggest strong predictability of monetary policy on liquidity at an aggregate

market level and individual stock level. The effect of monetary policy on liquidity is stronger

during low sentiment (pessimistic) periods as compared to high sentiment (optimistic) periods.

1
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Author’s Note: Byomakesh Debata was affiliated with the Indian Institute of Technology

Kharagpur, Kharagpur, West Bengal, India, when this paper was submitted to the journal.

Keywords: Investor sentiment; India; Liquidity; Monetary policy; Emerging stock market

Introduction

The sudden liquidity dry-up in the financial markets, particularly during the 2007-2008

global financial crisis, has amplified 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 economic crisis

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(Trichet, 2010) further corroborate the argument. Given the role of the stock market as a

monetary policy transmission mechanism, the impact of monetary policy 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 conditions as a determinant of

stock market liquidity has 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 prevailing market sentiment.

Using data from the order-driven Indian stock market we try to address these two important

issues. Our empirical approach closely follows Fernández-Amador, Gächter, 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 element 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 monetary 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 asymmetries in the effects of monetary policy on stock

market 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 variables. We use

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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 Following the top-down approach of Baker and Wurgler

(2006), we construct a sentiment index using seven implicit orthogonal 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),

Fernández-Amador et al. (2013) and Chowdhury et al. (2018). Consistent with Goyenko and

Ukhov (2009) and Fernández-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 asymmetric effect on the monetary policy--stock market liquidity relationship. The effect of

monetary policy on liquidity is stronger during low sentiment (pessimistic) periods as compared

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 monetary

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

literature by providing empirical evidence on the monetary policy and liquidity relationship,

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 market 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.

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during high and low investor sentiment periods. This paper is perhaps the first to suggest a

possible asymmetric effect of investor sentiment on the monetary policy--stock market liquidity

relationship.

The rest of the paper is organised as follows. The successive sections present a literature

review and motivation of the study; the data and sample characteristics; the measurement of

variables; the methodology; the empirical test 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 relationship

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; Pástor & Stambaugh, 2003).

Given the importance of market liquidity for investment decision and economic policies,

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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 commonality 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; Fernández-Amador et al., 2013; Friedman &

Schwartz, 1963; Nyborg & Östberg, 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 (Hasbrouck, 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 associated

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;

Brunnermeier & Pedersen, 2009). The Brunnermeier and Pedersen (2009) model suggests that

market participants with capital constraints find it difficult to meet their margin requirements,

and, in turn, fail to provide liquidity. Conversely, corrosion of market liquidity increases the cost

of capital, which reduces traders’ funding liquidity. Following these arguments, an expansionary

(contractionary) monetary policy is anticipated to reduce (increase) the cost of margin borrowing

of traders and facilitate (deter) funding liquidity.

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There are several motivating factors for this research. There is a limited amount of research

available on the relationship between monetary policy and stock market liquidity in the pure

order-driven market. Available research work (Chordia et al., 2005; Fernández-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 generate liquidity

demand and supply schedules that are consistent 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. market 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 predictability 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 determinant which can forecast market liquidity for all the three stock exchanges.

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Fernández-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 market 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

empirical 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 diversification 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 portfolio performance due to high liquidity

premium expectation (Lesmond, 2005). As documented by Lo and Mackinlay (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

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emerging market on the monetary policy--liquidity relationship. The Indian stock market serves

as an ideal candidate 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 literature it also emerges that the monetary policy transmission

mechanism in developing countries is dependent on the development of the financial system,

level of internal market integration, bank or market-based financial system, central 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 monetary 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 monetary 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 & Mishra, 2012).

Concurrently, the focus of monetary policy shifted from direct instruments such as selective

credit controls 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

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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 interest 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 impact of monetary policy on stock market

liquidity is not yet settled upon in the related literature. The effect of monetary 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 literature 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

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sentiment for pricing of risky financial assets has gained considerable attention in finance

literature. Behavioural 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). Consistent with the scope of this paper, in the

following paragraphs 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 sensitive 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 theoretical arguments, existing literature asserts that

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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 asymmetric effect on the market and that the effect of monetary

policy on stock returns is influenced by the state of the market i.e., bull (optimistic) or bear

(pessimistic) market. Specifically, 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

bear‐market 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 sentiment. 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 unconventional monetary

policy in the determination of investor sentiment.

It is therefore established that prevailing market sentiment can be an important aspect that

influences market liquidity and monetary policy transmission to the stock market. However,

there is no study that highlights the importance of investor sentiment in influencing the monetary

policy--stock market liquidity relationship. If investor sentiment can individually influence the

market liquidity and monetary policy transmission, then it is plausible to argue that investor

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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 provides a more comprehensive examination of

monetary policy--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 market, we chose April 2002 as the starting point of

our sample period. The Security Exchange Board of India (SEBI) abolished 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 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

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stocks to determine daily return, daily volatility, and liquidity proxies. Then, the daily measures

were averaged 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 number 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 control variables, and the investor sentiment variables.

Liquidity variables

Liquidity is a broad and elusive concept (Amihud, 2002; Pástor & 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). Liquidity, 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 market 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

https://www.rbi.org.in/scripts/AnnualPublications.aspx?head=Handbook%20of%20Statistics%2
0on%20Indian%20Economy
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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, trading 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 structures 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 & Mendelson, 1986; Amihud, 2002, Florackis,

Gregoriou, & Kostakis, 2011; Corwin & Schultz, 2012) we have employed five different

liquidity proxies to capture various attributes 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 description of liquidity proxies

used in this study is shared as supplementary material accompanying the online version of the

article (Table S1)

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Monetary policy variables

We have approximated the monetary policy stance of the central bank through monetary

aggregate and interest rate. Taking a cue from Fernández-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 Fernández-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 policy decisions of monetary authority.

It is also evident from the extant literature that interest 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

context 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 transmission 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 quarters 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 macroeconomic conditions, stage of the domestic business cycle, the domestic liquidity, financial conditions,
the fiscal stance, and the health of the domestic banking sector (Acharya, 2017). Considering the average 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 publications for the components of money stock, select economic indicators,
and reserve money, components and sources prefer to measure the year–on–year growth rate of reserve money following a 12-
month horizon.
4
Similar to Fed rate for the US and Euro overnight index average for the Euro Central Bank.

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Control variables

A related strand of literature supports the fact that macroeconomic 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 formulation. 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 variables. 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 capital, 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 Fernández-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 documented that individual firm

characteristics may influence stock liquidity. For example, Brunnermeier and Pedersen (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

5
The post economic liberalisation period has witnessed a rapid growth in the flow of FII to India. It has increased
from US$ 1635 million during 2002-03, to US$ 226,103 million in the financial year 2014-15 (SEBI, 2015).

17
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liquidity (Copeland & Galai, 1983). Consistent 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 variables. 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 variables 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.

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

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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

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

0.00-

RET __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.

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, INDEX) are presented in Table 1. Panel A shows the descriptive statistics. Panel B depicts

the correlation structure among the variables. Some interesting observations emanate from the

correlation matrix. The liquidity measures (TV and TR) are negatively associated with STDV

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and have a positive 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 relationship 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 information. We observe a positive

association between money supply (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 augmented Dickey-Fuller (1981) (ADF),

Phillips-Perron (1988) (PP), and Kwiatkowski, Phillips, Schmidt, and Shin (KPSS) (1992) unit

root tests to examine stationarity of variables. The optimal lag for ADF test and truncation lag

for PP test are selected based on the Akaike information criterion (AIC) and Schwarz

information criterion (SIC) criteria. The unit root tests reveal that the null hypothesis of unit root

is rejected for all the liquidity measures, macroeconomic variables, volatility and stock returns at

first difference (with and without intercept and trend). Since most of the liquidity variables are

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stationary at first difference, 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 variables in their first difference in our model. The unit root tests result for ADF, PP and

KPSS are shared as supplementary material accompanying the online version of the article

(Table S2). The Inclan and Tiao (1994) structural break test reveals that there is no sudden shift

or trend break in the time series. For the purpose of brevity, we do not report Inclan and Tiao

(1994) structural break test results.

Investor sentiment

We measure investor sentiment (SENT), following the top-down approach of Baker and

Wurgler (2006) to construct a sentiment index. Using seven implicit sentiment proxies i.e.,

advance decline ratio (ADR), put-call ratio (PCR), number 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 (SENT) following the approach of Baker and

Wurgler (2006). Considering the theoretical arguments in related literature6 the sentiment index

(SENT) can be presented as:

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 positive 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 measure of overvaluation in the market
and hence a positive sentiment indicator.

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We orthogonalise each of the sentiment variables using fundamental 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 relative 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).

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 liquidity 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.

Time series estimation

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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

alternative to simultaneous equation models. Unlike the classical simultaneous equation models,

VAR is free from any arbitrary restriction. Sims (1980) highlights that if there exists any

simultaneity among the variables, then there should not be any distinction between endogenous

and exogenous variables 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 fundamentals, 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 trading

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 market, particularly

during crisis periods as a minimum level of liquidity is required for smooth functioning of

financial markets. 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 leading indicator of the

real economy and sudden drying-up of liquidity in financial markets is a precursor to crisis or

distress 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:

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∑ ∑ (2)

∑ ∑ (3)

where X vector represents the monthly stock market liquidity measures at time t-i. Y vector

represents the monthly measures of monetary policy and control variables (macroeconomic as

well as market variables) at time t-i. i representing the minimum lag length, and are the

coefficients of lagged value of X vector, and and the coefficients of lagged value of Y

vector, and are the error terms of equation (2) and (3), respectively. This model examines

whether stock market liquidity and monetary policy 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. Second,

the sign of the coefficients of lagged variables changes 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 weaknesses, 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 variables on the

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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 monetary 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 decomposition of VAR residuals and place the variables in the order they influence

each other. We further examine the predictability of monetary policy by employing variance

decomposition. 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 policy and other control variables.

Panel-regression model

Consistent with Fernández-Amador et al. (2013), we employ panel-regression models to

investigate the effect of monetary policy on liquidity of individual stocks. The model is specified

as follows:

…….. (4)

th
where j stands for j cross-sectional unit and t for the tth time period, and c is the intercept term.

Slope coefficients are represented by α1, α2, α3 and α4; is the error term which is assumed to

have mean zero and constant variance. 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)

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at time t are represented by . The vector represents the firm-specific control variables,

such as RET, STDV, SZ. The macroeconomic control variables, i.e., , , and the

are represented by the vector . 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 heterogeneity (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 (LR) test (Gouriéroux, Holly, & Monfort,1982) has been 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 check the acceptability of panel data models over

classical regression models. Hausman test (Hausman, 1978) has been conducted to choose a

suitable panel data model such as the fixed-effect 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 policy 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-causality test, IRFs, and variance decomposition. The VAR examines the relationship

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between stock market liquidity and monetary stance. This approach entails a total of 10 different

VAR estimates, each of which allows for 42 Granger-causality tests. For brevity, we report only

the Granger-causality tests between five liquidity proxies and two monetary 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 VAR Granger-causality tests for the entire sample

Panel (A): Granger causality tests: Monetary policy and stock market liquidity

( : Monetary policy does not Granger cause stock market (il)liquidity)

Variables TV TR ILLIQ TPI HLS

CMR 4.11 {0.05} 1.10 {0.35} 1.33 {0.20} 10.45 {0.00} 9.59 {0.00}

RM 4.74 {0.02} 0.80 {0.37} 4.01 {0.05} 2.25 {0.13} 1.96 {0.31}

Panel (B): Granger causality tests: Liquidity variables and monetary policy

( : Stock market (il)liquidity does not Granger cause monetary policy)

Variables CMR RM

TV 0.22 {0.64} 0.89 {0.35}

TR 0.15 {0.87} 0.31 {0.58}

ILLIQ 0.90 {0.35} 2.37 {0.12}

TPI 0.12 {0.84} 0.53 {0.47}

HLS 2.98 {0.09} 0.88 {0.36}

Note: This table presents χ2 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.

Table 2 reports the χ2 statistics and p-values of pairwise Granger causality tests between

endogenous VAR variables. Panel (A) of Table 2 depicts that the monetary policy variables

(CMR and RM) are informative in predicting stock market liquidity. We find the change in CMR

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significantly Granger causes trading activity, price impact, and transaction cost measures (TV,

TPI, and HLS). There is a unidirectional causality observed from RM to TV and ILLIQ.

Interestingly, Panel (B) of Table 2 documents very little evidence of causality from stock

market liquidity to monetary policy. There is a unidirectional causal relationship between

monetary policy and stock market liquidity. We do not observe any bidirectional causality.

Overall, the empirical results support the notion that monetary policy plays an essential role in

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determining the stock market liquidity (Chowdhury et al., 2018; Fernández-Amador et al., 2013).

Our results, however, do not support Chowdhury et al’s (2018) findings of reverse causality from

Amihud's (2002) illiquidity measure (ILLIQ) and TPI measure to monetary policy variables

(CMR, RM).

To understand the dynamic interaction among the variables 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

reaction of stock market liquidity for every unit standard deviation innovation in the monetary

policy variables. The response of stock market liquidity to unit standard deviation change in

call-money rate (CMR), traced forward throughout 24 months is shown in Figure S1 in the

supplementary material accompanying the online article. 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 expansionary monetary policy, which

is characterised by lowering interest rate or increasing the money supply, strengthens aggregate

market liquidity. Also, tightening of monetary policy is associated with a decline in aggregated

stock market liquidity. Our findings from IRFs are consistent with those of Goyenko and Ukhov

(2009), Fernández-Amador et al. (2013), and Chowdhury et al. (2018). Furthermore, we carry

out variance decomposition to know the percentage of stock market liquidity explained by

macroeconomic variables, particularly monetary policy. For brevity, we have reported the

variance decomposition of liquidity variables only.

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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 comparison 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.

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)

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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.

Our broad results in this study reveal that monetary policy changes significantly Granger-

cause stock market liquidity. 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 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

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

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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.

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policy and financial market liquidity 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), statistical 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 identification 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.

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)

( : 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)

( : Monetary policy does not Granger cause stock market liquidity)

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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 χ2 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), turnover 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.

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 standard 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 accompanying the online version of the article.

Consistent with our hypothesis, both the figures reveal that a positive shock to monetary policy

significantly affects 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 variance decomposition analysis across sub-samples and found that the

findings are consistent with our whole sample periods. (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

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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 measures 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 illiquidity

measures. The results support our hypothesis that the tightening of monetary policy adversely

35
 36

affects stock liquidity. Most of the signs are in line with our hypothesis 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 funding 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

observations 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” (Chakraborty, 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 corroborate the implication of reserve-money

growth rate (RM) on firm specific (il)liquidity measures. Overall, our results confirm 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 liquidity,

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 37

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

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)

-0.0715*** -0.0555*** 0.2176** 0.0012* 0.0005

(-19.30) (-11.48) (3.10) (2.99) (0.73)

0.0141*** 0.0036*** -0.0430*** 0.0010 -0.0001***

(23.69) (19.60) (-8.05) (0.89) (-10.00)

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)

-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)

-0.0005*** -0.0002*** 0.0002*** 0.0001 -0.0010* 0.0005*** 0.0002*** -0.0002 0.0001 -0.0009**

(-7.30) (11.89) (12.50) (0.91) (-2.70) (5.57) (9.98) (-0.88) (0.83) (-2.96)

-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)

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)

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)

37
 38

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)

2
LR Test [χ (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 [χ2(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 [χ2(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
2
Adj. R 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 available

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 classical 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.

38
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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 & 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 intermediaries 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 accompanying the online article.

Monetary policy, liquidity and investor sentiment

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.

39
 40

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

explanation concerning noise trading and sentiment induced trading behaviour of market

participants has emerged as a possible determinant of stock market liquidity (Baker & 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 different market

regimes i.e., high sentiment (bullish) versus low sentiment (bearish) periods.

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)

( : 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)

( : 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 χ2 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. Sample period for Panel (A) and (B) represent the higher and lower

40
 41

investor sentiment periods estimation results respectively. Figures in the curly brackets show p-values. ***, **,* indicate

significance at 1%, 5% and 10% level respectively.

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

during high sentiment periods the relationship between monetary 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 periods. 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 analysis 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 standard 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,

41
 42

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 monetary policy and stock market liquidity relationship is more

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:

where 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 Equation (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 during high sentiment periods. We use OLS

method and Newey and West’s (1987) robust standard errors to estimate Equation (5). Table 8

reports the estimated results of Equation (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 sentiment periods the expansionary monetary policy has a positive 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

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 43

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 Burgler (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 consistent for firm level liquidity. In order to test this

hypothesis, we try to estimate our firm level panel estimation (Equation 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 sentiment environments

and not to view the interaction of sentiment with monetary policy, we have not used the

interaction effect of sentiment dummy variable with monetary 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

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

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 44

-0.23*** -0.05 0.04** 0.01 0.33***

(-3.11) (-1.12) (2.10) (0.50) (2.55)

0.001 0.03** -0.002 -0.08* -0.12***

(0.68) (2.17) (-0.40) (-1.78) (-5.44)

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)

-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)

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)

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

-0.08 -0.12** 0.09*** 0.001 0.40***

(-1.10) (-2.22) (3.71) (0.77) (4.25)

0.22 0.35** -0.02 -0.07 -0.02

(1.68) (2.78) (-1.04) (-1.23) (-0.94)

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)

-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)

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)

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), illiquidity ratio (ILLIQ),

turnover price impact (TPI), high-low spread (HLS). The monetary policy variables are CMR, RM. Control variables are IP, IR, FII, INDEX.

44
 45

Investor sentiment (SENT) is measured consistent with Baker and Wurgler (2006). The high (low) sentiment period is characterised as the

periods in which the sentiment values are greater (lesser) than the median sentiment value. Detailed description of all variables 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.

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

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)

-0.08 -0.05 0.22** 0.04 0.00

(1.24) (-1.12) (2.12) (0.77) (0.33)

0.30** 0.28*** -0.02 -0.05 -0.01

(2.29) (3.85) (-1.10) (-1.28) (-0.56)

-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)

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)

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)

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)

-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)

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)

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 228 320 298 310 368 312 208 333 456 {0.00} 527

[χ2(509)] {0.00} {0.00} {0.00} {0.00} {0.00} {0.00} {0.00} {0.00} {0.00}

Hausman Test 456 521 680 720 656 517 606 810 923 {0.00} 711

[χ (9)]
2 {0.00} {0.00} {0.00} {0.00} {0.00} {0.00} {0.00} {0.00} {0.00}

45
 46

D-W Stat 2.08 2.02 2.05 2.20 2.28 2.17 1.91 2.31 2.44 2.60
2
Adj. R 0.62 0.75 0.56 0.49 0.68 0.68 0.72 0.60 0.51 0.75

F-statistics 89 100 125 183 212 112 95 160 185 198

(509, 44580) {0.00} {0.00} {0.00} {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

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)

-0.38*** -0.14** 0.3*** 0.01 0.27***

(3.79) (-2.18) (3.54) (0.55) (4.41)

0.27** 0.3*** -0.02 -0.00 -0.34***

(2.30) (4.14) (-1.19) (-0.58) (-8.56)

-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)

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)

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)

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)

-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)

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)

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 311 298 189 400 288 410 236 311 422 {0.00} 626

[χ2(509)] {0.00} {0.00} {0.00} {0.00} {0.00} {0.00} {0.00} {0.00} {0.00}

Hausman Test 519 410 580 789 823 489 589 855 {0.00} 787 {0.00} 929

[χ2(9)] {0.00} {0.00} {0.00} {0.00} {0.00} {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
2
Adj. R 0.71 0.62 0.66 0.53 0.74 0.60 0.68 0.55 0.49 0.64

F-statistics 112 134 156 200 189 233 155 288 202 346

(509, 43820) {0.00} {0.00} {0.00} {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

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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.

independent variable are lag values of liquidity proxies, monetary policy variables (CMR and

RM), macro-economic variables (IP, IR,FII), firm specific control 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 matters 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 illiquidity effect argument (Amihud, 2002) we

observe a positive (negative) sign of SZ for liquidity (illiquidity) proxies.

Conclusion and implications

This paper examines the relationship between monetary policy and stock market liquidity in

a pure order-driven emerging stock market. Our robustness test accounts for possible

asymmetries in the effects of monetary policy on stock market liquidity in different market

regimes i.e., optimistic (high sentiment) versus pessimistic (low sentiment) market environment.

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

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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 attributed to monetary

policy. Consistent with aggregate market liquidity, the panel estimation results suggest that an

expansionary monetary policy significantly leads to an increase in the individual stock liquidity.

Overall, we document a strong predictability of monetary policy on liquidity. Our findings are

consistent with Goyenko and Ukhov (2009), Fernández-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 compared to high sentiment periods. Our findings lend

support to the argument that investor sentiment is an essential 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 management for enhancing stock market liquidity

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should consider the sentiment environment in the market. To sum-up, since liquidity 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

Details of the supplementary material are as follows:

• Tables S1, S2, S3

• Figures S1, S2, S3, S4, S5, S6, S7, S8

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