Money Supply and Stock Prices: A Probabilistic Approach

A relationship between money supply and stock prices is fairly well recognized in the literature. More recently the studies of Hamburger and Kochin [7], Modigliani [12], Keran [9], and Homa and Jaffee [8] have attempted to specify the short- and long-run nature and the direct and indirect nature of these relationships. Also, these studies have focused on determining the transition variables through which the money-supply effect is transmitted to stock prices. A more pragmatic approach is that of Sprinkel [17 and 18] and Palmer [14] who have attempted to analyze the money-supply and stock-market relationships to see if the former can be a predictor of the latter. More reliable forecasts of future market movements, if available, could be extremely useful for individual and institutional investors. At one extreme, information could be used to time the investment in and out of the market portfolio. Alternatively, the investor could more profitably use the B information on market volatility of stocks available from the capital-asset pricing model, relating expected rate of return on a security, E(Ri), with that on the market portfolio, E(Rm). Accordingly, the prediction of the market would indicate when to shift the composition of the portfolio from relatively low to high or from relatively high to low β stocks and cash.