How Money Supply Can Affect Stock Prices Finance Essay

Unexpected alterations in money supply can be due to revenue enhancement actions, alterations in involvement rates, alterations in price reduction rates among other factors. Stock returns are by and large positive or negative. In this essay, the motivation is to happen whether the statement, ‘unexpected alterations in money supply and stock returns are reciprocally related, ‘ holds land or is non valid. To get down with, we will first expression at the money supply procedure in brief and see which factors affect stock return. Post this we will corroborate the empirical cogency of this statement with the aid of grounds available in the literature.

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The Money Supply Process

Bodie, Kane, Marcus and Mohanty ( 2009, p.592 ) explain that the Government can pull strings the money supply through the usage of financial and pecuniary policies. Fiscal policy refers to authorities disbursement and revenue enhancement actions and is considered the most direct manner to excite or decelerate the economic system. Federal Reserve System ( FED ) determines the pecuniary policy which by and large functions through its impact on involvement rates. Short term involvement rates decrease due to increase in money supply, finally encouraging investing and ingestion demand. Over long periods, nevertheless, most economic experts believe a higher money supply leads to higher monetary value degrees. An illustration of pecuniary policy working through unfastened market operations can be illustrated as below:

*Note: Unlike us, the FED can pay for security without pulling down financess at a bank history

From Bodie, Kane, Marcus and Mohanty ( 2009 ) , we can contract down the undermentioned factors related to money supply affect stock return:

Inflation

Interest rate ( price reduction rate )

Monetary growing

Empirical Evidence

Whether unexpected alterations in money supply are positively or negatively related to stock returns seems to be a subject debated by many research workers. At one terminal where many international research workers have found a important 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 manus a positive relationship is proved by rather a few research workers ( Fama, 1981 ; Geske and Roll, 1983 ; Kaul, 1987 ; Zhao, 1999 ; Luintel and Paudyal, 2006 ) .

Consequence of Discount Rate/ Interest rate on Stock return

Chen et Al. ( 1999 ) found that equity returns by and large respond negatively and significantly to the unexpected proclamations of price reduction rates. They ground this out by saying:

‘A price reduction rate addition, ceteris paribus, decreases the expected future equity hard currency flows because houses must borrow at a higher cost. At the same clip, the addition besides raises the riskless rate which, in bend, increases the needed rate equity investors use to dismiss the future hard currency flows. As a consequence, an unexpected addition in market involvement rates depresses equity monetary values, and, hence, one would anticipate an unexpected alteration in the Federal Reserve price reduction rate to do alterations in equity monetary values. ‘

However, there have been contrasting positions associating to the pre-1979 period. Research carried out by Smirlock and Yawitz ( 1985 cited in Thorbecke and Alami, 1994, p.14 ) have found that alterations in the price reduction rate had no consequence on the NYSE index over the pre-1979 period. Pearce and Roley ( 1985 cited in Thorbecke and Alami, 1994, p.14 ) did happen that inventions in the hebdomadal money supply proclamations lowered stock monetary values during this period.

A farther research by Thorbecke and Alami ( 1994 ) , over the September 1974 to September 1979 period, concludes that the Fed elevation ( take downing ) the federal financess rate mark caused stock monetary values to worsen ( addition ) instantly.

Consequence of Inflation on stock return

The rate at which general degrees of monetary values rise is called rising prices ( Bodie, Kane, Marcus and Mohanty, 2009 )

Harmonizing to the efficient market hypothesis, stock monetary values are a mark of all available public information ; therefore, merely the unexpected rising prices rate, which contains new information, will act upon stock returns at the clip when the proclamation is released ( Joyce and Read, 2002 ) . Consistent with the efficient market hypothesis, L. Li et Al. ( 2010 ) found that the expected rising prices rate has really small impact on stock returns while the unexpected rising prices rate has a statistically important and negative consequence on stock returns.

Amihud ( 1996 ) provinces

‘The grounds that stock monetary values are affected by unexpected rising prices seemed perplexing given that stocks are claims on income generated by existent assets. But unexpected rising prices indicates an economic daze, hence its consequence depends on its beginning. Aggregate demand dazes should make positive correlativity between the ensuing unexpected rising prices and stock monetary values, whereas aggregate supply dazes should make negative correlativity. The research on Israel concluded that rising prices has a important negative consequence on stock monetary values. ‘

The consequence of rising prices on stock returns, in footings of clip skylines is cited by Luintel and Paudyal ( 2006 ) in their research. They province, ‘event surveies, which look at the effects of rising prices proclamations on stock returns, report a negative relation between rising prices and stock returns ( e.g. , Amihud 1996 ) . Short-horizon surveies that use monthly informations covering what is typically 10 to 15 old ages besides report either a negative or an undistinguished relation between stock returns and rising prices ( e.g. , Jaffe and Mandelker 1976 ) . In contrast, long-horizon surveies ( e.g. , Boudoukh, Richardson, and Whitelaw 1994 ) and surveies that test for cointegration between stock and trade good monetary value indexes ( e.g. , Ely and Robinson 1997 ) happen a positive and important relation between stock returns and rising prices. ‘

Consequence of pecuniary growing on stock returns

Paudyal ( 1990 ) points out that money growing and stock returns are reciprocally related.

Pearce and Roley ( 1983 ) shed more visible radiation on this subject. They infer that first, stock monetary values respond merely to the unforeseen alteration in the money supply as predicted by the efficient markets hypothesis. Second, an unforeseen addition in the proclaimed money supply depresses stock monetary values while an unforeseen lessening elevates stock monetary values. Third, the stock monetary value response does non depend on the relationship of the money supply to the long-term scopes of the Federal Reserve. Using hebdomadal informations 1977-1982, they estimated the undermentioned theoretical account,

a?†Pt= a + B ( a?†Mat – a?†Met ) + Iµt

Where a?†Pt is the per centum alteration in the stock monetary value, a?†Mat is the proclaimed alteration in the money stock, and a?†Met is the expected alteration in the money stock. They estimated the theoretical account for three sub-periods and obtained a negative estimation of B parametric quantity in each sub-period.

Decision

As stated earlier, unexpected alterations in money supply can be due to revenue enhancement actions, alterations in involvement rates, alterations in price reduction rates among other factors. Stock returns are by and large positive or negative. In this essay, I ab initio explained the money supply procedure. Following, we studied some empirical grounds to look into if unexpected alterations in money supply had an reverse consequence on stock return or non. Although few consequences did province the otherwise, most consequences showed that factors which affect money supply did hold an reverse consequence on stock returns. In decision we can farther look at a few more precise points made in certain research documents.

Chen et Al. ( 1999 ) find that few equity returns react negatively and significantly to the unexpected proclamations of price reduction rate alterations, while the expected alterations by and large have no bearing on the equity returns. On norm, stock returns alteration by 0.5 % for every 10 footing point alteration in the price reduction rate. Equity returns measured by the Dow Jones industrial index respond instead quickly to the unexpected proclamation of price reduction rate alterations. Within the trading period/hour after the information is released, the market impounds the information.

Hardouvelis ( 1987 ) has discussed, a higher existent involvement rate would cut down stock monetary values because foremost it would restrict existent activity and hence net incomes and secondly it would increase the price reduction rate at which those net incomes were discounted.

L. Li et Al. ( 2010 ) determine that 1 twenty-four hours returns of the FTA autumn by 0.17 % in response to an addition in the unexpected rising prices rate of 1 % on the proclamation twenty-four hours. Therefore, an unexpected addition in the rising prices rate is considered bad intelligence for the stock market since this leads to a decrease in stock monetary values.

Therefore through the empirical grounds we have assessed, we can deduce that the statement ‘unexpected alterations in money supply and stock returns are reciprocally related, ‘ holds land to a respectable extent.

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