The effect of changes in money supply on stock returns has
been a matter of controversy among economists for many decades. Those in
favour of presence of links between money market and stock market argue
that any change in money supply creates a wealth effect which disturbs
the existing equilibrium in the portfolio of investors. When they
re-adjust their asset portfolio, a new equilibrium is established in
which the price level of various assets is changed. On the other hand,
if the stock market is efficient, it would already have incorporated all
the current and anticipated changes in money supply. Consequently, a
causal relationship between changes in money supply and stock prices
will not be established. Moreover if the change in money supply
coincides with a corresponding change in the velocity of money, it will
not have any effect on stock prices. The pioneering work in this regard
was done by Sprinkel (1964). Using the data from 1918 to 1960, he found
a strong relationship between stock prices and money supply in the
United States. His conclusions, however, were mostly based upon
graphical analysis.
The Velocity of Money and the Stock Market. A Comparative Forward and Backward Analysis
