‘Unexpected changes in money supply and stock returns are inversely related’. Discuss the process through which money supply may affect stock prices and critically assess the empirical validity of this statement with the help of evidence available in the literature.
Stock returns reflect investor expectations about corporate performance in terms of earnings, cash flow and required rate of return. They are one of the better leading indicator series in any economy and react to various leading indicator series like corporate profit margin, interest rate and money supply. (Keith & Brown, 2006).
The term money supply is a monetary variable that refers to the quantity of money issued by a country’s monetary authority. It is the total amount of money available in an economy at a particular point in time. An increase in money supply usually results in excess money pursuing few goods and services within the economy, these include stocks.
Some processes of this relationship include:
Policy Anticipation Hypothesis
Here, market participants interpret economic announcements based on the implication for monetary policy. As a result, when macroeconomic news arrives economic agents review their expectations of upcoming policy decisions and interest rates move accordingly (Burger John, 2004). Unexpected increase in money supply can cause the central bank to increase the rate of interest. The effect of this is that the return on other fixed income securities like treasury bills and bonds which are substitutes of equity goes up, causing a decline in stock price.
When money supply increases in the economy, there is a higher demand for equity. Investors tend to switch to equity because of its promised higher return over bonds, causing an increase in the stock price.
The Keynesian Hypothesis
Another possible link between money and asset prices is through the expected real rate. For this link to work, actual innovations in money affect the ex ante (based on anticipated changes in an economy) real rate creating a liquidity effect because the price level does not respond instantaneously to monetary shocks. This hypothesis predicts that in response to announcement of an unexpected increase in the money supply, stock prices will decline.
The Real Activity Hypothesis
Here, money demand depends on expected future output, individual agents cannot determine aggregate money demand, because other agents’ expectations are unobservable, thus money supply announcements provide information about expected future output. For example, an unanticipated increase in the money stock tells agents that aggregate money demand is greater than they forecast. On the basis of this information, estimates of future real activity rise. With higher expected future output, the real rate must rise to clear the market for consumption and investment. In addition, the increase in expected output leads to a rise in the current demand for money. It therefore predicts that in response to an unexpected increase in the money supply, stock prices will rise.
Expected inflation hypothesis
This hypothesis states that announcement of an unanticipated jump in the money stock leads to expectations of higher inflation and to an increase in short-term interest rates, while announcement of an unanticipated drop in money has the reverse effect. Thus, in response to an unexpected increase in the money supply, stock prices may move up or down depending on the role of taxes, nominal contracting by firms and other markets imperfections (Bradford C., 1983). When there is excess money in the economy, there is likely to be inflation. Inflationary expectations in the economy have a positive impact on the nominal interest rate and also the required rate of return, motivating asset holders to substitute other financial assets for money n their portfolio (Fama ’70, Cagan ’72, Pearce ’87). The effect of this is a decline in stock price.
For many years, the economic impact of changes in money supply has been debated in academic discussions (Richard & Joseph: 1974), It is generally agreed that an unexpected increase or decrease in the growth rate of money results in a change in the equilibrium position of money with respect to other assets in the portfolio of investors.
The quantity theory of money states that an increase in the money supply results in a change in the equilibrium position of money with respect to other assets, including equity shares, in the portfolio balance of asset holders. As a result, asset holders adjust the proportion of their portfolios represented by money balances. This adjustment alters the demand for other assets that compete with money balances, including equity shares. An increase in the money supply is expected to create excess supply of money balances and, in turn, excess demand for shares. Share prices are expected to rise as a result. (Brunner, 1961; Friedman, 1961; and Friedman and Schwartz, 1963)
Friedman etal (1963) explained a positive relationship between changes in growth rate of money supply and changes in the economy. They posit that the impact of money supply is part of the transmission process where money supply affects the aggregate economy.
Studies by Cooper and Rozeff (1971) found that unexpected changes in growth rate of money supply consistently lagged stock returns by about 1 – 3 months.
Eric Sorensen (1982) using a two-stage regression model in his analysis finds out that unanticipated changes in money supply have a larger impact on the stock market than anticipated changes, supporting the efficient market hypothesis.
Davidson and Foyer(1982) and Hayen (1985) found out that money supply changes affect stock prices but stock prices adjust very quickly to the unexpected changes, making it necessary to forecast these unexpected changes.
Pearce and Roley (1983, 1985) found out that stock prices respond only to the unanticipated change in the money supply. This inverse relationship shows that an unanticipated increase in the announced money supply depresses stock prices while an unanticipated decrease elevates stock prices. New information related directly to monetary policy significantly affects stock price and their sample proves that money announcement surprises have a significantly negative effect on stock prices; therefore, anticipated components of economic announcements do not significantly affect daily stock price movements, which is consistent with the policy anticipation hypothesis.
Milton Friedman’s (1988) study that the inverse relation between stock prices and monetary velocity means that a rise in stock prices means an increase in nominal wealth and generally, given the wider fluctuation in stock prices than in income, also in the ratio of wealth to income. The higher wealth to income ratio can be expected to be reflected in higher money to income ratio or a lower velocity. It could also reflect an increase in the expected return from risky assets relative to safe assets which could be offset by increasing the weight of relatively safe assets in an aggregate portfolio; imply a substitution effect. The higher the real stock price, the more attractive are equities as a component of the portfolio.
However, Jensen, Johnson & Mercer (1996) proved that the results of several studies before theirs can significantly be affected by the prevailing monetary environment.
Fazal Husain and Tariq Mahmood (1999), in their study find that money supply causes changes in stock prices not only in the long run, but also in the short run, predicting that the stock market is not efficient with respect to the money supply, or in other words, finding that the efficient market hypothesis does not persist
Sellin (2001) argues that money supply will affect stock prices only if the change in money supply alters expectations about future monetary policy. He holds that a positive money supply shock will lead people to anticipate tightening monetary policy in the future. The subsequent increase in bidding for bonds will drive up the current rate of interest. As the interest rate goes up, the discount rates go up as well, and the present value of future earnings decline. As a result, stock prices decline.
Furthermore, the real activity economists, on the other hand argue that a change in the money supply provides information on money demand, which is caused by future output expectations. If the money supply increases, it means that money demand is increasing, which, in effect, signals an increase in economic activity, implying higher cash flows, which causes stock prices to rise.
Bernanke and Kuttner (2005) argue that the price of a stock is a function of its monetary value and the perceived risk in holding the stock. A stock is attractive if the monetary value it bears is high. On the other hand, a stock is unattractive if the perceived risk is high. They believe that tightening the money supply raises the real interest rate which would in turn raise the discount rate and decrease the value of the stock.
Money supply has been suggested as a problem of aggregate market behaviour based on its relationship to the economy. Early studies indicate a strong relationship between money supply and stock price and suggest that money supply changes turned before stock price. Subsequent studies confirmed the link between money supply and stock price but indicated that stock price turn with or before money supply changes. Most recent results show that monetary policy has an important impact on security market returns and also affects how stocks relate to other variables (Keith & Brown, pg. 455).
However unexpected changes in money supply and stock returns are related, but the degree to which their relationship can be measured is dependent on other economic variables operating within the economy.