Monetary Expansion and Stock Returns in Pakistan

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.