The impact of monetary disturbances on stock prices

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Virginia Tech

A key issue in this paper is whether or not stock prices may be predicted based on information obtained by predicting money supply growth. Based on the evidence presented in this paper the conclusion is no.

First, there is a strong contemporaneous correlation between money growth and stock price changes. There is little correlation with lagged money growth. Information regarding historical data on the money supply would not provide a means of forecasting stock prices. This information is already discounted in the price of the stock.

Second, the evidence on expected and unexpected money growth shows a lack of significance in the expected variable coefficients. This is consistent with the rational expectations (efficient markets) theory that only unexpected changes will have an effect on stock prices. Further evidence is that generally only contemporaneous unexpected money growth is strongly significant.

One way of analyzing an efficient markets-oriented model of money's affect on stock prices is a two-step approach which was used in this analysis. The first step was to develop a model to forecast money growth. The predicted values and residuals from the forecasting model were then used as proxies for expected and unexpected variables, respectively. In the second step, these variables then served as regressors to predict changes in the stock market price in a second equation.