The quantity theory of stock prices

Abstract

ABSTRACT We determine the implications of the Modern Quantity Theory of Money for the nominal pricing of equity stocks. Our analysis is compatible with the hypothesis that the ratio of the quantity of money in circulation to a comprehensive index of stock prices evolves in terms of an elastic (that is, mean reverting) random walk. Using annual U.S. data covering the period from 1871 until 2018 shows that the ‘half-life’ of the period it takes for the money to stock price ratio to converge towards its long-run mean, is around fifteen years. Our empirical analysis also shows that unexpected inflation has a disruptive impact on the output and investment decisions implemented by firms and leads to an increase in the money to stock price ratio (equivalently, the stock price index falls relative to the quantity of money in circulation). We also develop a framework for determining how economic agents can rebalance their investment portfolios in response to disequilibria in the money to stock price ratio and thereby maximise the expected discounted utility obtained from their future consumption.