Unexpected changes in money supply can be due to tax actions, changes in interest rates, changes in discount rates among other factors. Stock returns are generally positive or negative. In this essay, the motive is to find whether the statement, ‘unexpected changes in money supply and stock returns are inversely related,’ holds ground or is not valid. To begin with, we will first look at the money supply process in brief and see which factors affect stock return. Post this we will confirm the empirical validity of this statement with the help of evidence available in the literature.
The Money Supply Process
Bodie, Kane, Marcus and Mohanty (2009, p.592) explain that the Government can manipulate the money supply through the use of fiscal and monetary policies. Fiscal policy refers to government spending and tax actions and is considered the most direct way to stimulate or slow the economy. Federal Reserve System (FED) determines the monetary policy which generally functions through its impact on interest rates. Short term interest rates decrease due to increase in money supply, ultimately encouraging investment and consumption demand. Over long periods, however, most economists believe a higher money supply leads to higher price levels. An example of monetary policy functioning through open market operations can be illustrated as below: *Note: Unlike us, the FED can pay for security without drawing down funds at a bank account From Bodie, Kane, Marcus and Mohanty (2009), we can narrow down the following factors related to money supply affect stock return: Inflation Interest rate (discount rate) Monetary growth
Whether unexpected changes in money supply are positively or negatively related to stock returns seems to be a topic debated by many researchers. At one end where many international researchers have found a significant negative relationship (Bodie, 1976; Jaffe and Mandelker, 1976; Fama and Schwert, 1977; Amihud, 1996; Hu and Willett, 2000; Hagmann and Lenz, 2004), on the other hand a positive relationship is proved by quite a few researchers (Fama, 1981; Geske and Roll, 1983; Kaul, 1987; Zhao, 1999; Luintel and Paudyal, 2006). Effect of Discount Rate/ Interest rate on Stock return Chen et al. (1999) found that equity returns generally respond negatively and significantly to the unexpected announcements of discount rates. They reason this out by stating: ‘A discount rate increase, ceteris paribus, decreases the expected future equity cash flows because firms must borrow at a higher cost. At the same time, the increase also raises the risk-free rate which, in turn, increases the required rate equity investors use to discount the future cash flows. As a result, an unexpected increase in market interest rates depresses equity prices, and, therefore, one would expect an unexpected change in the Federal Reserve discount rate to cause changes in equity prices.’ However, there have been contrasting views relating to the pre-1979 period. Research carried out by Smirlock and Yawitz (1985 cited in Thorbecke and Alami, 1994, p.14) have found that changes in the discount rate had no effect on the NYSE index over the pre-1979 period. Pearce and Roley (1985 cited in Thorbecke and Alami, 1994, p.14) did find that innovations in the weekly money supply announcements lowered stock prices during this period. A further research by Thorbecke and Alami (1994), over the September 1974 to September 1979 period, concludes that the Fed raising (lowering) the federal funds rate target caused stock prices to decline (increase) immediately. Effect of Inflation on stock return The rate at which general levels of prices rise is called inflation (Bodie, Kane, Marcus and Mohanty, 2009) According to the efficient market hypothesis, stock prices are a sign of all available public information; therefore, only the unexpected inflation rate, which contains new information, will influence stock returns at the time when the announcement is released (Joyce and Read, 2002). Consistent with the efficient market hypothesis, L. Li et al. (2010) found that the expected inflation rate has very little impact on stock returns while the unexpected inflation rate has a statistically significant and negative effect on stock returns. Amihud (1996) states ‘The evidence that stock prices are affected by unexpected inflation seemed puzzling given that stocks are claims on income generated by real assets. But unexpected inflation indicates an economic shock, hence its effect depends on its source. Aggregate demand shocks should create positive correlation between the resulting unexpected inflation and stock prices, whereas aggregate supply shocks should create negative correlation. The research on Israel concluded that inflation has a significant negative effect on stock prices.’ The effect of inflation on stock returns, in terms of time horizons is cited by Luintel and Paudyal (2006) in their research. They state, ‘event studies, which look at the effects of inflation announcements on stock returns, report a negative relation between inflation and stock returns (e.g., Amihud 1996). Short-horizon studies that use monthly data covering what is typically 10 to 15 years also report either a negative or an insignificant relation between stock returns and inflation (e.g., Jaffe and Mandelker 1976). In contrast, long-horizon studies (e.g., Boudoukh, Richardson, and Whitelaw 1994) and studies that test for cointegration between stock and commodity price indexes (e.g., Ely and Robinson 1997) find a positive and significant relation between stock returns and inflation.’ Effect of monetary growth on stock returns Paudyal (1990) points out that money growth and stock returns are inversely related. Pearce and Roley (1983) shed more light on this topic. They infer that first, stock prices respond only to the unanticipated change in the money supply as predicted by the efficient markets hypothesis. Second, an unanticipated increase in the announced money supply depresses stock prices while an unanticipated decrease elevates stock prices. Third, the stock price response does not depend on the relationship of the money supply to the long-run ranges of the Federal Reserve. Using weekly data 1977-1982, they estimated the following model, A¢Ë†” Pt= a + b (A¢Ë†” Mat – A¢Ë†” Met) + AAµt Where A¢Ë†” Pt is the percentage change in the stock price, A¢Ë†” Mat is the announced change in the money stock, and A¢Ë†” Met is the expected change in the money stock. They estimated the model for three sub-periods and obtained a negative estimate of b parameter in each sub-period. Conclusion As stated earlier, unexpected changes in money supply can be due to tax actions, changes in interest rates, changes in discount rates among other factors. Stock returns are generally positive or negative. In this essay, I initially explained the money supply process. Next, we studied some empirical evidence to check if unexpected changes in money supply had an inverse effect on stock return or not. Although few results did state the otherwise, most results showed that factors which affect money supply did have an inverse effect on stock returns. In conclusion we can further look at a few more precise points made in certain research papers. Chen et al. (1999) find that few equity returns respond negatively and significantly to the unexpected announcements of discount rate changes, while the expected changes generally have no bearing on the equity returns. On average, stock returns change by 0.5% for every 10 basis point change in the discount rate. Equity returns measured by the Dow Jones industrial index respond rather rapidly to the unexpected announcement of discount rate changes. Within the trading period/hour after the information is released, the market impounds the information. Hardouvelis (1987) has discussed, a higher real interest rate would reduce stock prices because firstly it would curtail real activity and hence earnings and secondly it would increase the discount rate at which those earnings were discounted. L. Li et al. (2010) determine that 1 day returns of the FTA fall by 0.17% in response to an increase in the unexpected inflation rate of 1% on the announcement day. Therefore, an unexpected increase in the inflation rate is considered bad news for the stock market since this leads to a reduction in stock prices. Thus through the empirical evidence we have assessed, we can infer that the statement ‘unexpected changes in money supply and stock returns are inversely related,’ holds ground to a respectable extent.