Expansionary economic policy leads to increases in the stock market because it generates increased economic activity. Policymakers can implement expansionary policy through monetary and fiscal channels. Typically, it is employed when the economy is slipping into a recession and inflationary pressures are dormant.
Fiscally, expansionary policy will lead to increases in aggregate demand and employment. This translates into more spending and higher levels of consumer confidence. Stocks rise, as these interventions lead to increased sales and earnings for corporations.
Fiscal policy is quite effective in stimulating economic activity and consumer spending. It is simple in its transmission mechanism. The government borrows money or dips into its surplus and gives it back to consumers in the form of a tax cut, or it spends the money on stimulus projects.
On the monetary side, the transmission mechanism is more circuitous. Expansionary monetary policy works by improving financial conditions rather than demand. Lowering the cost of money will increase the money supply, which pushes down interest rates and borrowing costs.
This is particularly beneficial for the large multinational corporations, which make up the bulk of the major indexes of the stock market, such as the S&P 500 and Dow Jones Industrial Average. Due to their size and massive balance sheets, they carry huge amounts of debt.
Decreases in interest rate payments flow straight to the bottom line, pumping up profits. Low rates prompt companies to buy back shares or issue dividends, which is also bullish for stock prices. In general, asset prices do well in an environment as the risk-free rate of return rises, specifically income-generating assets such as dividend-paying stocks. This is one of the goals of policymakers to push investors to take on more risk.
Consumers get relief as well with expansionary monetary policy due to lower interest rate payments, improving the consumer balance sheet in the process. Additionally, marginal demand for major purchases such as automobiles or homes also rises as financing costs decrease. This is bullish for companies in these sectors. Dividend-paying sectors such as real estate investment trusts, utilities and consumer staple companies also improve with monetary stimulus.
In terms of what is better for stocks – expansionary fiscal policy or expansionary monetary policy – the answer is clear. Expansionary monetary policy is better. Fiscal policy leads to wage inflation, which decreases corporate margins. This decrease in margins offsets some of the gains in revenue. While wage inflation is good for the real economy, it is not good for corporate earnings.
With monetary policy due to the transmission mechanism, wage inflation is not a certainty. A recent example of the effect of monetary policy on stocks has been after the Great Recession, when the Federal Reserve cut interest rates to zero and started quantitative easing. Eventually, the central bank took on $3.7 trillion worth of securities on its balance sheet. Over this time period, wage inflation remained low, and the S&P 500 more than tripled climbing from its low of 666 in March 2009 to 2,100 in March 2015. (For related reading, see "What Are Some Examples of Expansionary Monetary Policy?")