We do pay attention to monetary policy effects on the nominal (inflation) and real sectors of the economy (investment and growth rate). In this respect, two monetary policies are considered. The first one involves affecting the FEM and the policy of exchange rate unification to lower the gap between official and unofficial exchange rates. The second one involves using monetary policy instrument of IR in order to influence the nominal and real sectors of the economy through the channels of the FIs (stock market and bank deposits) and speculation in the FEM, in other words, evaluating the direct and indirect impacts of IR on the economy. Given the policies mentioned above, it is essential to review the relationship between the FIs and the FEM with each other and with the nominal and real economic indicators. Since the monetary policy is supposed to affect the economy through these markets and its direct effects. Hence, to this aim, we review the related literature in the following four sub-titles.
The FIs and the nominal and real sectors of an economy
Levine (1999, 2005, 2000), and Greenbaum et al. (2019) state that the FIs have a positive impact on investment and economic growth through their roles in increasing transparency, reducing asymmetric information, facilitating transactions and trade, risk management, and lowering the costs of accessing to investment opportunities in order to attract and optimally allocate resources to productive economic activities. Some studies, such as Fufa and Kim (2018) and Seven and Yetkiner (2016), approved the positive effect of the banking sector and the stock market on economic growth. Schumpeter (1954) and McKinnon (1982) also assert that the FIs can be effective on growth rate due to their vital role in financing investment. On this basis, an essential part of the World Bank’s recommendations to the economies is to support structural reformations that the most important of those have been not repressing NIR and exchange rate and development of the stock market and banking sector (Balogun et al. 2016).
The firm’s financing in all economies is centered on the banking sector and stock market, any of which has a relatively large share in some economies than the other (Levine 2002). The financing system is market based in high-income countries (Demirguc-Kunt and Levine 1999) and bank based in developing ones (Moradi et al. 2016). There might be a competition between the FIs to attract liquidity. Hence, they try to absorb more liquidity through offering financial services and investment opportunities (Mattana and Panetti 2014). However, the FIs can complement each other because of the banking sector’s investment in the stock market and supply funds to the firms listed on the stock market (Adrian and Shin 2010).
On the other hand, economic conditions can also affect the FIs (Demirguc-Kunt and Levine 1999; Greenwood and Smith 1997; Sadeghi et al. 2021). Since in the economic boom, firms’ earnings increase, which has an expected positive impact on the stock market (Bahmani-Oskooee and Saha 2016). Accordingly, since IR is being affected by economic conditions, the incentive of investing in bank deposits is also affected (Boyd et al. 2001).
Inflation can have two different effects on the stock market. The positive effect is due to the growth of firms’ products price, and the negative effect is due to rising input prices and, thus, their cost effect (Al-haji et al. 2018; Chen et al. 1986). Another channel of inflation’s effectiveness is its potential impact on RIR, which can affect the attractiveness of bank deposits and, therefore, the costs of financing firms from bank deposits through changing the motivations to lend and borrow (Boyd et al. 2001). On the other hand, the stock market can also affect the inflation rate through the wealth effect channel. With a change in the stock market’s return, individuals’ expected income and wealth will also change. After that, household consumption, aggregate demand, and inflation will be affected (Simo-Kengne et al. 2015).
Rangan and Inglesi-Lotz (2012) and Antonakakis et al. (2017) confirm that inflation might affect the stock market and can be affected by the stock market. This bidirectional relation can be positive or negative, which is confirmed by Valcarcel (2012). Friedman (1977) states that rising inflation will harm investment due to growth of uncertainty and risk in the economy. Thus, the stock market will also be affected negatively (Apergis and Eleftheriou 2002). Tobin (1965) states that rising inflation positively affects the stock market because of devaluing cash value, savings, and thus injecting liquidity into the capital assets. Al-haji et al. (2018), based on Fisher’s (1930) study, discuss that after increasing inflation, investment in the stock market increases to cover the risk of depreciation of some assets. Some studies, such as the study of Boyd et al. (2001), have confirmed the negative effect of inflation on the banking sector and the stock market. Solarin et al. (2018) showed the negative effect of inflation on bank deposits, and on the contrary, Finger and Hesse (2009) found out that inflation had a positive effect on bank deposits. In the studies, like Bahmani-Oskooee and Saha (2016), inflation’s effect on the stock market has been negative in some countries and positive in some other ones. Antonakakis et al. (2017) found out that the impact of inflation on the stock market has been significant but different in different periods. The study of Thampanya et al. (2020) concluded that inflation affected the stock market positively.
The relationship of FEM with the nominal and real sectors of the economy
The studies of the World Bank have shown that the growth of exchange rate can increase bank deposits and, consequently, the growth of capital accumulation, investment, and economic growth. The best example is China where has benefited from this policy and achieved high economic growth. Some Asian countries, such as South Korea, Malaysia, and Thailand, did the same, and hence, their GDP and saving rate have shown high growth. On this basis, the net exports and, consequently, domestic savings will also grow after increasing the exchange rate, which causes the growth of competitiveness of exporting domestic goods in international markets and going up the import costs. As the saving rate grows, the needed domestic sources for financing the investment could be provided (Montiel and Serven 2008). Yeyati and Sturzenegger (2010) have also confirmed a rise in the exchange rate, and consequently, the increase of domestic savings to finance investments will lead to economic growth.
Concerning the effects of exchange rate on economic growth, the current views contrast with each other. Another view believes that the increase of exchange rate harms investment and economic growth due to the growth of the relative prices, domestic inflation, and more uncertainty in the economic environment (Montiel and Serven 2008; Dooley et al. 2004). There is a view that emphasizes the impacts of exchange rate on the economy depend on the structure of domestic economic firms. More specifically, the dependence of domestic firms on the measure of imported input against their exporting products might be a determinant factor (Bahmani-Oskooee and Saha 2016). As Comunale and Simola (2018) have approved, it relates to the relationship between exchange rate and inflation. The exchange rate pass-through on the inflation rate has been investigated by plenty of studies (Kurtovic et al. 2018). Ho and Odhiambo (2018) showed the negative effect of inflation on the exchange rate. In contrast, Delgado et al. (2018) reached a positive bidirectional relationship between inflation and exchange rates. On the other hand, the national currency value can also be affected by conditions of investment, economic growth, and inflation rate (Tayebi and Sadeghi 2017; Chiu and Sun 2016). In this regard, estimating the impacts of exchange rate changes on the inflation rate and then the monetary policy response to that has always been a challenge for central banks (Ghartey 2019).
The relationship between the FEM and the FIs
In the case of price instability and its high fluctuations in financial markets, the opportunity to profit from speculation due to high capital gains is provided, and thus, a substitute market is formed for the FIs in attracting liquidity. One of the financial markets that have the potential of high volatility and getting multi-rated due to the difference between official and unofficial rates is the FEM. Allen and Gale (1997) state that the difference between speculative activities and the FIs in attracting liquidity is related to their risk. Investors will take more risk when they expect a higher expected return. If they estimate more profit from the speculation than the FIs, they will choose the speculation. Dornbusch and Fisher (1980) and Bahmani-Oskooee and Saha (2016) express that a currency depreciation enhances the export-based firms’ income by reinforcing the competitiveness of their products in the international markets.
In contrast, the firms whose input is more dependent on importing might be affected negatively by a decrease in national currency value because of rising import costs. Therefore, given its impact on the profitability of export-based firms or relied on import of input, the FEM has the potential of different effects on the stock market. In this respect, Aggarwal (2003) found out that the effects of exchange rate fluctuations on stock price depend on their impacts on the firms’ products and input price. Franck and Young (1972) also confirmed that its impact depends on the structure of the firms. Exchange rate fluctuations also can affect bank deposits regarding their impact on the stock market, net exports, economic growth, and domestic savings. On the other side, given the potential effectiveness of the FIs on investment and economic growth that is a strong backup for the national currency, the FEM can also be mutually influenced by the conditions of the FIs. In this regard, Branson (1981) expresses that the exchange rate might be affected by capital assets price.
Some economic events and empirical studies have confirmed the existence of a negative correlation between financial markets. During the financial crisis of 2008–2009, the trust in the banking network had faded (Gregorioua et al. 2016), and the US stock market had also lost plenty of its value. The Federal Reserve led the investors’ liquidity to the stock market by taking advantage of expansionary monetary policy, bond buying, and lowering IR (Huang et al., 2016). Matana and Panetti (2014) have confirmed the negative correlation between bank deposits and the stock market. Solarin et al. (2018) reached a negative relationship between bank deposits and the FEM. The negative relation between the FEM and stock market has also been confirmed in several studies (Al-haji et al. 2018; Delgado et al. 2018; Huang et al., 2016; Assefa et al. 2017).
In contrast, some other studies have rejected the negative correlation between some of these markets and considered them as complement and reinforce each other due to the positive correlation. The stock market index in the study of Solarin et al. (2018) showed a positive relationship with bank deposits. Chen and Chiang (2016) and Ho and Odhiambo (2018) also reached the positive effect of the exchange rate on the stock market. The positive relation between banking credits and the stock market is also confirmed by the study of Ho and Odhiambo (2018).
Despite being confirmed of a significant bidirectional relation between the FEM and stock markets (Manasseh et al. 2019 and Thampanya et al. 2020), some studies have not shown a significant relationship with bank facilities (Mbutor, 2010). Chkili and Nguyen (2013) considered a non-linear relation for the stock market and the FEM. This study shows that the exchange rate has not significantly affected the stock market in both regimes of high and low fluctuations. In contrast, the stock market has shown a significant impact on the exchange rate in both regimes. The study of Samadi et al. (2021) also shows that there can be no significant relationship between the stock market and the FEM.
Monetary policy, the FIs, and the FEM
Central bank’s monetary decisions concerning changing IR can potentially impact stock market fluctuations, the FEM, bonds (Lyócsa et al. 2019), and cash value. Hence, the investors consider the IR changes on their decisions (Moya-Martínez et al. 2015). The financial crisis of 2008–2009, which slowed down the growth of the global economy, increased the attention to the potential of monetary policy and its IR instruments. IR is one of the determinants of stock price, and its relation with the stock market has considerable importance in financial economics (Moya-Martínez et al., 2015). Hashemzadeh and Taylor (1988) argue that a lower IR could positively affect the stock market through the growth of the current value of the future return. Furthermore, IR can affect economic growth by influencing the stock market (Balogun et al., 2016). In addition, IR is one of the influential factors in the absorption of bank deposits (Finger and Hesse 2009). By changing IR, the effects of monetary policy can be injected into the economy’s real and nominal sectors through the channel of affecting the FIs and the FEM. It is confirmed by Blinder (1998). Adrian and Shin (2010) also emphasize the transition of monetary policy effects to the economy’s real sectors through the channel of the FIs.
IR can be effective on bank deposits’ attractiveness and, consequently, the firms’ access listed on the stock market to bank loans for investing and, thus, their profitability outlook (El Wassal 2005; Yartey 2008). The effects of monetary policy on real sectors of an economy considerably depend on the status of the FIs (Terra and Arestis 2017; Beck et al. 2014). The changes of IR affect investors’ decisions to choose between risky assets and bank deposits. After rising IR, the investors might prefer bank deposits to risky assets. It increases the lending power of banks. Thus, the manufacturing sectors have more access to banking loans, leading to more investment (Beck et al. 2014). However, IR can also have a different and dual effect because it might increase the cost of financing the investment from bank loans, leading to a decrease in investment (Montiel and Serven 2008). Therefore, the performance and profitability perspective of the firms will be affected negatively by that. Some studies have confirmed the positive effect of IR on the growth of bank deposits (Mushtaq and Siddiqui 2017; Mashamba et al. 2014; Solarin et al. 2018; Ojeaga et al. 2013).
Nevertheless, the positive effect of raising IR on bank deposits in empirical studies that have mostly been related to Islamic countries has often been rejected. They found it out ineffective. (Hassan 2016; Mushtaq and Siddiqui 2017). Studies, such as Balogun et al. (2016), have shown the negative impact of IR liberalization on stock market development. Al-haji et al. (2018) and Huang et al. (2016) have also confirmed the negative effect of IR. In contrast, the study of Thampanya et al. (2020) found out that IR affects the stock market positively, and some others did not show a significant effect (Assefa et al. 2017). As a result, the changes of IR might affect the investors’ decision about investing in bank deposits or the stock market. For example, bank deposits will be less attractive than bank deposits if IR decreases because the RIR of bank deposits reduces, while the financing cost of the firms listed on the stock market decrease. Nevertheless, the impact of this substitution is not clear on real sectors of an economy. Does it depend on whether the stock market will be able to compensate for the reduction of firms’ access to financial resources of bank deposits or not? (Drechsler, Savov and Schnabl 2018; Lin 2020).
IR has enough potential to affect money demand and, therefore, the exchange rate due to its impact on the opportunity cost of holding money (Walsh 2010) and the attractiveness of the domestic economy to absorb foreign investment (Chen et al. 2016; Snowdon and Vane 2005). On the other hand, IR can affect the exchange rate through the channel of effectiveness on the FIs and, consequently, on investment and economic growth (El Wassal 2005; Yartey 2008), which are considered a strong backup for national currency value. Friedman states that if the return rate of different assets (money, stocks, bonds, and commodities) is not equal, the investors will tend to the assets with a higher return rate (Wright 2012). Given the possible effect of IR on money demand, exchange rate, and real return rate of bank deposits, the foreign currencies, and bank deposits can be added to the assets list considered by Friedman. However, some studies have not confirmed the effect of IR on exchange rates (Saraç and Karagöz 2016), and some others have shown a significant relationship between them (Taylor and Peel 2000).
Finally, given the existing four sub-titles, the monetary policy effects can be transmitted to the economy through the FIs and the FEM channel. As Blinder (1998), Allen and Gale (2004) and Adrian and Shin (2010) did confirm that. In this regard, Fernández-Amador et al. (2013) state that the intervention of central banks in the financial markets has been risen by applying the monetary policy to stabilize the markets and economic conditions after the financial crisis in 2007–2008.