Is Money Creation Fueling the Stock Market Surge?steemCreated with Sketch.

in #mises7 years ago

Mises.org Frank Shostak
Is it true that changes in money supply are an important driving force behind changes in the stock price indexes?

Intuitively it makes sense to argue that an increase in the growth rate of money supply should strengthen the growth rate in stock prices.

Conversely, a fall in the growth rate of money supply should slow down the growth momentum of stock prices.

Some economists who follow the footsteps of the post-Keynesian (PK) school of economics have questioned the importance of money in driving stock prices.1 It is held that rises in stock prices provide an incentive to liquidate long-term saving deposits, thereby boosting the money supply.

The received money then employed in buying stocks and other financial assets. According to the PK the trend is reversed when stock prices are falling. Hence, changes in stock prices cause changes in money supply and not the other way around.

The Definition of Money Supply

In today’s monetary system, coins and notes constitute the standard money, known as cash. At any point in time part of the stock of cash is stored, that is, deposited in banks. Once an individual places his money in a bank’s warehouse he is in fact engaging in a claim transaction. In depositing his money, he never relinquishes money with a bank, he continues to have an unlimited claim against it and is entitled to take charge of it at any time. These deposits, labelled demand deposits, are part of money. Thus, if in an economy people hold $10,000 in cash, we would say that the money supply of this economy is $10,000. But, if some individuals have stored $2,000 in demand deposits, the total money supply will remain $10,000: $8,000 cash and $2,000 in demand deposits—that is, $2,000 cash is stored in bank warehouses. Finally, if individuals deposit their entire stock of cash, the total money supply will remain $10,000, all of it in demand deposits.

This must be contrasted with a credit transaction, in which the lender of money relinquishes his claim over the money for the duration of the loan. Credit always involves a creditor’s purchase of a future good in exchange for a present good. As a result, in a credit transaction, money is transferred from a lender to a borrower.

The distinction between a credit and a claim transaction serves as an important means of identifying the amount of money in an economy. Following this approach, one could easily note that, notwithstanding popular practice, money invested with money market mutual funds (MMMF) must be excluded from the money supply definition.

Investment in a money market mutual fund is in fact an investment in various money-market instruments. The quantity of money is not altered as a result of this investment; only the ownership of money has temporarily changed. Including investment in MMMFs in the money definition will only lead to a double-counting thereof.

If Joe invests $1,000 with an MMMF, the overall amount of money in the economy will not change as a result of this transaction. To incorporate the $1,000 invested with the MMMF into the definition of money would therefore amount to double-counting.

The crux in identifying what must be included in the money supply definition is to adhere to the distinction between a claim transaction and a credit transaction. Following this principle, it is questionable whether savings deposits should be part of the money supply.

According to popular thinking, the inclusion of savings deposits into the money supply definition is justified on the grounds that money deposited in saving accounts can always be withdrawn on demand. But the same logic should also be applied to money placed with an MMMF. The nub, however, is that savings deposits do not confer an unlimited claim. The bank could always insist on a waiting period of thirty days during which the deposited money could not be withdrawn.

Savings deposits should therefore be considered credit transactions with depositors relinquishing ownership for at least thirty days. This fact is not altered just because the depositor could withdraw his money on demand. When the bank accommodates this demand, it sells other assets for cash. Buyers of assets part with their cash, which in turn is transferred to the holder of the savings deposit. The same logic is applicable to fixed-term deposits like CDs, which are credit transactions.

Mainstream thinking currently excludes from the money supply government deposits held in banks and the central bank . Consequently, if the government taxes people by one billion dollars, money is transferred from their deposits to the government’s deposit. This is viewed just as if the money supply fell by one billion dollars. In reality, however, the money is now available for government expenditure, meaning that money held in government deposits should be part of the definition of money. Incorporating all the above arguments, the money supply is defined as follows:

Cash+demand deposits with commercial banks and thrift institutions+government deposits with banks and the central bank.

If changes in savings deposits does not alter money supply obviously, changes in various savings deposits i.e. including long term have nothing to do with changes in the stock of money as suggested by the PK.

Furthermore, contrary to the PK, is it possible that prices of assets in general will increase without a preceding increase in money supply? After all a price of a good is the amount of money per unit of the good. In order then to have a general increase in prices, all other things being equal, there must be an increase first in the money supply.

Given, that the key source of monetary expansion is the central bank monetary policies and the fractional reserve banking we can conclude that it is these that drive the stock prices.