Sensitivity Of Stock Prices To Money Supply Dynamics

Abstract

Financial theory models typically relate stock prices with inflationary shocks that emanates from an expansionary monetary policy. Literature generally supports the causality relationship between money supply and stock prices due to price volatilities in the real interest rate. This paper attempts to determine causality between money supply and stock prices using monthly share prices and money supply quantities from 2011- 2013. The results of the study support the recent evidence against the positive affiliation between money supply and stock prices. The study uses the Johansen cointegration test and the Vector Error Correction Models (VECM) models for testing causality relationship between money supply and stock prices. While the expectation was that there should exist a statistically significant positive affiliation between money supply and stock prices, results of the tests reject this ideal. However, the results are plausible when interest rate factors are included in the analysis. It is concluded that money supply shocks provide robust changes in the stock prices