Money supply, interest rate, liquidity and share prices: A test of their linkage using panel data of G-7 countries
Date of this Version
This paper reports new evidence of a liquidity effect on share prices from money supply changes. Money supply impacts on interest rate and liquidity were first proposed in 1969 and there is evidence that money supply increase leads to interest rate declines. Yet the proposition that money supply increase should lead to liquidity surges – thus to credit expansion – has yet to receive unanimous empirical support. Using panel quarterly data over 1968-2011 for G-7 countries, our results from a two-stage simultaneous solution of a system of equations indicate that money supply changes lead to a positive liquidity effect, as per the theory prediction. By extending the liquidity equation to asset prices, we also show that liquidity change has a significant positive effect on share prices, after controlling the effects of earnings, policy regime changes and global financial crisis. These findings, obtained after solutions to serious econometric issues of existing studies, appear to provide a clear verification of theory on the money supply effect on liquidity and on asset price.
This document has been peer reviewed.