Understanding The Role of Monetary Policy in Shaping Malaysia’s Stock Market Liquidity

Abstract

Research Question: This study examines whether monetary policy influences stock market liquidity in Malaysia and whether the strength of this relationship varies across firms of different market capitalizations. Motivation: Monetary policy decisions can affect not only macroeconomic conditions but also the functioning of capital markets. Understanding their effects on stock market liquidity is particularly important for emerging markets, where liquidity conditions may differ considerably across firms. Greater understanding of this transmission mechanism can assist monetary authorities and capital market regulators in maintaining financial market stability while supporting efficient capital allocation. Idea: The study investigates two key channels through which monetary policy may influence stock market liquidity: the liquidity provision channel, represented by M1 money supply growth, and the interest rate channel. It further considers firm size to determine whether monetary policy effects are transmitted differently across market capitalization groups. Data: The analysis uses monthly Malaysian data covering the period from 2006 to 2022, providing a sufficiently long period to capture different monetary and financial market conditions. Method/Tools: Multiple linear regression analysis is employed to estimate the relationship between monetary policy and stock market liquidity. The analysis incorporates monetary policy indicators and examines differences in their effects across firms based on market capitalization. Findings: The results demonstrate a significant relationship between monetary policy and stock market liquidity. Expansionary monetary policy, reflected by higher M1 money supply growth, enhances stock market liquidity, whereas contractionary monetary policy, represented by higher interest rates, reduces liquidity. The effects of monetary policy are also more pronounced among smaller-capitalization stocks, indicating that firm size plays an important role in the transmission of monetary policy to equity market liquidity. Contributions: This study contributes to the literature by providing evidence on the transmission of monetary policy to stock market liquidity in an emerging-market setting and by demonstrating that this transmission varies according to firm size. The findings also highlight the importance of coordination between monetary authorities and capital market regulators, as accommodative monetary conditions can improve market liquidity and capital allocation but may also contribute to excessive market activity and associated financial stability risks.