Abstract
Recent years have witnessed the birth of a revolutionary idea: Monetary policy and the money supply can affect the stock market directly-without first influencing the economy or investor expectations. The previous explanation for the market soaring in the midst of recession or plummeting in the midst of boom was that investors were correctly forecasting the coming trough or peak in business activity and attempting to anticipate by changing their portfolios. This was never a very satisfactory model because it did not fit the behavior of real investors. A new explanation suggests that changes in the money supply, caused by the Federal Reserve's expanding the supply in recessions and restricting it in booms, can create excessive or deficient liquidity among investors. Such excesses or deficiencies, according to this theory, cause investors to increase or decrease holdings of stocks irrespective of the investment outlook. At first glance, the new explanation has great appeal. It explains why investors act in the stock market before turns in the business cycle, without imputing to them superior forecasting ability. And it is wrapped in the mantle of monetary economics, which is currently enjoying a vogue among economic theorists. When one looks deeper, however, he may find it hard to specify exactly what the links are by which monetary policy directly influences the stock market. At this point he can either accept the explanation on a black box basis or ignore it. A better alternative is to seek an understanding of these missing links. Beryl Sprinkel's pioneering work, Money and Markets: A Monetarist View, offers one theory:
Published Version
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