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On the relationship between stock prices and the quantity of money

University of British Columbia

The old Quantity Theory of the Value of Money can be expressed as the "Equation of Exchange," MV=PT, in which M is the quantity of money, V is the velocity of circulation of money, P is the price level, and T is the total number of transactions during the period under consideration. The major shortcoming of the old Quantity Theory was that velocity (V) was taken to be numerically constant, which it is not. The new Quantity Theory is a theory of the demand for money as an asset, productive capital yielding a stream of income in the form of convenience, security, and so on. According to this theory, people hold portfolios containing money, bonds, equities, and other assets, and they adjust their portfolios so that they obtain the maximum returns therefrom. The demand for money can be expressed in terms of the demand for other assets (in real terms), the behaviour of the general price level, people's utility preferences, and their total wealth. Given a function describing total income, an equation describing the velocity of circulation of money can be written as the quotient of the income function divided by the demand for money function. This is the difference between the new and old Quantity Theories: under the old, the velocity of money was considered to be a numerical constant; under the new it is described as a function of income and the demand for money. In accordance with the above theory, when a monetary disturbance is introduced by the central bank, people will want to adjust their portfolios in such a way as to compensate for the disturbance. The initial impact of the monetary disturbance is in the markets for the most liquid assets: the financial markets. This idea was tested by correlation analysis on Canadian data of money supply and stock prices and variants thereof for the years 1924-1967. Even after the influence of trend had been removed from the data, statistical support was found for the above theory, but only after the influence of random variation had been reduced by six-month moving averaging. However, the evidence—a significant correlation of .259 between percent change in money and percent change in stock prices—suggests that monetary change accounts for only about 6.7 percent of the variation in stock prices. But this conclusion must be tempered by the realisation that variable lags of the same nature as those that exist between monetary change and change in the level of business activity can be expected to exist between monetary change and change in the level of stock prices. Thus it can be argued that the results of correlation analysis tend to understate the actual impact of monetary change on stock prices.

Text

2012-03-29

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http://hdl.handle.net/2429/41880

Business Administration

University of British Columbia

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