Expected Monetary Changes and Relative Prices: A Look at Evidence from the Stock Market

Abstract

At the heart of the natural rate theory is the assumption that fully perceived monetary growth is neutral with respect to relative price changes. Unfortunately, there have been few attempts to test this assumption directly. Because the belief that active contracyclical monetary policies are not superior to Friedman's constant growth rule rests upon the assumption that expected monetary changes have neutral relative price effects, more evidence is needed on whether such changes are, in fact, neutral. To this end, we test the hypothesis that only the unexpected components, and not the expected components, of monetary changes affect relative price changes by looking at the stock market. Testing is done on a modification of the well known mean-variance Capital Asset Pricing Model, the CAPM. Specifically, we modify the CAPM to allow for differential stock returns depending upon expected and unexpected monetary growth rates. Section II explains the basic model used to test for non-neutral relative price effects of monetary change. Section III deals with the empirical definitions of expected and unexpected money growth. Section IV discusses the basic data while Sections V and VI make neutrality tests of monetary growth using actual, expected, revisions in expected, and unexpected money growths. The last part summarizes the paper.