Money and Stock Prices: The Channels of Influence

The authors note several flaws with prior studies regarding the money supply and stock prices.  In particular, most of the recent studies only use the period after the Korean war, the studies only find an indirect relationship (e.g., through changes in interest rates or earnings), and they generally neglect the risk aspect which has been a tenant of investment research.

The authors go into explaining how the change in money supply affects all the components of the earnings discount model (i.e., the risk-free yield, earnings expectations, and the risk premium); ***note that Homa/Jaffee (1971) used a dividend discount model.***  The authors first discuss the "liquidity effect", whereby more money supply reduces the risk-free rate; they suggest that stock prices may be more responsive, in the short run, to changes in the money supply than bonds.  Next is the "earnings effect", whereby increases in the money supply create more demand for goods/services which translates into greater corporate profits; they suggest that changes in the money supply precede changes in stock prices which precede changes in earnings.  Finally, the authors discuss the "risk premium effect", whereby greater volatility of money supply levels may cause greater volatility in the economy requiring an increase in the risk premium resulting in a reduction in stock prices.

The authors perform two studies.  In the first study (the "partial effect"), the authors follow a paper by Keran (1971) to investigate how the money supply affects stock prices through an econometric model.  Keran had suggested through his results that money supply only has an indirect effect on stock prices; however, the authors split several of the variables into their components (e.g., split interest rates into real and inflation components, etc) and find that money supply has BOTH an indirect and direct effect on stock prices.  That is, the money supply growth variable is still significant after making the regression more granular.  They find that the inflation relationship is now insignificant and the money supply changes are now a significant determinant of stock price levels.

In the second study (the "total effect"), the authors make the independent variables be lagged money growth rate going back in 9 successive quarters; the dependent variable is either the risk free rate, corporate bond rate, S&P stock index, or dividend yield in 4 separate equations.  They find that the equation with the stock price level as the dependent variable has a larger R^2 than Keran's regression in the "partial effect".  The authors use this as further evidence that the money supply has a direct effect on stock prices (not just indirectly through interest rates), contradicting the conventional wisdom.

The authors then go on to regress an equation using data back to 1871 in an effort to support the volatility of the money supply causing higher risk premiums.

HAMBURGER, M. J., & KOCHIN, L. A. (1972). Money and Stock Prices: The Channels of Influence. Journal of Finance, 27(2), 231–249.