Rational Expectations and the Impact of Money upon Stock Prices

The author notes the prior studies, noting significant relationships between money supply and stock prices; they also note that most recent studies have concluded that the stock market anticipates changes in the money supply and not the other way around.  Their addition to the area is by using the Barro equation, but splitting future changes in money supply into anticipated and unanticipated changes.  Under the efficient market hypothesis, unanticipated changes in the money supply would abruptly affect stock prices; however, expected changes would not.

He first uses the Barro equation to produce a regression with M2 as the dependent variable, and lagged money supply figures, the unemployment rate, and federal expenditures as the independent variables.  He shows these variable to explain 94% of the changes in M2 and to all be significant at a 95% confidence level.  In the second part, the author produces a regression with stock returns as the dependent variable; for the independent variables, he uses the previous money supply equation as the ANTICIPATED money supply changes, and he uses the residuals from this equation as the UNANTICIPATED money supply changes. 

The author found that the unanticipated changes in money supply were significant in changing stock returns; and the anticipated changes in money supply were insignificant.  He then produces the same equation with further lags, and the significance is even more pronounced in support of stock prices anticipating money supply changes.  He proposes that the link between money supply and stock returns found by other studies may in fact be a link between unanticipated changes in money supply and the act of sophisticated investors closing that gap.

Sorensen, E. H. (1982). Rational Expectations and the Impact of Money upon Stock Prices. Journal of Financial & Quantitative Analysis, 17(5), 649–662.