Does Money Supply and Liquidity Affect Share Prices?

Abstract

This paper reports results that link money supply to banking liquidity to share price formation. We apply a more current generalized method of moments procedure to run a three-equations structural model to study the money-to-liquidity-to-share-price effect in three major markets using data over 47 years. The first research question is on whether Friedman’s liquidity effect hypothesis is supported; Is there a money supply effect via liquidity on share price is the second question. The results show support for the liquidity hypothesis in all three markets: money supply through its liquidity creation influences share prices significantly. The tests included controls for monetary regime switches and the Global Financial Crisis. The resulting findings, obtained after solutions to some serious econometric issues in existing studies, provide clear verification of theories on money supply effect on liquidity and also on share price.

Keywords: Liquidity, Share prices, Endogeneity, Causality, Generalised Method of Moments, Structural break

JEL Classification: E41, E44