The Reaction of Stock Prices to Unanticipated Changes in Money

The authors first summarize the previous research; some of which was in support of money supply changes causing stock prices, and others rejecting that notion in support of the Efficient Market Hypothesis.  They also note more recent research that showed unanticipated changes in money supply caused a drop in stock prices; they cite several papers that attribute this effect to increased money supply causing investors to expect increased inflation, which depresses stock prices for a number of reasons (e.g., decreased real after-tax earnings, the opportunity cost of owning inflation linked assets like real estate and commodities, mistakes in comparing real returns to nominal returns, or Federal Reserve reactions and counter-measures such as raising interest rates).

The authors created a regression that included the change in stock prices as the dependent variable, and the actual minus expected change in the M1 as the independent variable.  To determine the expected change, they used the median expectation of about 60 money market participants in the weekly survey by Money Market Services.  They found that an unexpected increase in money supply of $1 billion usually caused a 0.7 fall in the stock price.  The regressions did, however, exhibit relatively small R^2s.

The authors consider several other questions related to this.  In particular, they find that stock price reactions to money supply changes become more volatile after the Fed beings its reserve-aggregate approach to monetary control; the stock price reactions to unanticipated changes in money supply is immediate; and stock prices do not move in anticipation of unexpected money supply changes.

PEARCE, D. K., & ROLEY, V. V. (1983). The Reaction of Stock Prices to Unanticipated Changes in Money: A Note. Journal of Finance, 38(4), 1323–1333.