In this model of the money market, the Fed could use open market operations - the purchase or sale of U.S. Your textbook might have had a graph like the one below. (Reserves are the cash banks hold in their vaults plus the deposits they maintain at Federal Reserve banks, and reserves influence the supply of money and credit in the economy.) government securities, it increases or decreases the level (or supply) of reserves in the banking system. It does this primarily by using daily open market operations. The Fed uses its monetary policy tools to influence the supply of money and credit in the economy. The story went something like this: The Federal Open Market Committee (FOMC), which is the main policymaking body of the Fed, sets a desired target for the federal funds rate (FFR) to move the economy toward the dual mandate. But an R 2 as high as 98.1% is scarcely found in financial modeling and should never be ignored by investors.Do you remember the economics course you took in high school or college? You might recall memorizing the three tools of monetary policy that help the Federal Reserve achieve its congressional mandate of maximum employment and price stability. Some may argue extrapolation based on a single-factor model may oversimplify the complexity of the financial market. As chart 4 depicts, S&P 500 index can reach 4651 points by the end of December 2021. Readers can then get a feel for the pace of the market. Here I am using it to predict the S&P 500 for the remaining months of 2021. So far I have established the connection between S&P 500 index and the M2 money supply. (Source: Author’s computations) Predicting S&P 500 Index This means that the model has been able to pick up 98.1% of the variations due to changes in M2. The corresponding linear regression model has the equation Y = 0.300X – 1431 with an R 2 of 98.1%. The highest correlation attained is 0.990830 that occurred at lag 8 of M2. Though the scatter plots at various lags of M2 resemble much under the naked eyes, their correlations with S&P 500 improve from lag 1 through lag 8. The accompanying table summarizes the regression results. (Source: Author’s presentation via Excel spreadsheet) We don’t have to go further because the best correlation has been identified at lag 8, implying that the best linear regression model can be constructed at that lag.Ĭhart 3 – Scatter Plots at Different Lags of M2 Underneath provides all the plots ranging from lag 1 to lag 12. We start by examining the scatter plots of S&P 500 vs M2 money supply at different lags of M2. In short, M2 is money that one can withdraw and spend, but which requires a greater effort to do so than those items listed in M1. It suits our choice because M2 includes everything in M1. Individuals holding government bonds are also part of the M2 category.įor this study, the money supply variable used is confined to M2. The M2 money supply is less liquid and includes M1 plus savings and time deposits, certificates of deposits, and money market funds. M1 money supply includes those monies that are very liquid such as cash, demand deposits, and traveler’s checks. Thus, there are two definitions of money: M1 and M2 money supply. Rather than using a single way of measuring money, the finance circle offers broader definitions of money based on liquidity. The circulating money involves the currency, printed notes, money in the deposit accounts and the form of other liquid assets. Money Supply can be defined as the total of money stock circulating in an economy. (Source: Federal Reserve and ) What is M2 Money Supply? With Biden’s 2020 ‘unlimited QE’ package, S&P 500 has surged 74.99% by August 2021. Not only were they growing almost in phase, but they also exhibited an increase in pace since the start of 2020. Money supply has dictated the market as interest rates were willfully destroyed.Ĭhart 2 illustrates how the two variables, M2 money supply and S&P 500, have been proceeding since January 2008. In the spring of 2009, the stock market was to finish its last dive and ready to rebound. On the other hand, liquidity kept hiking. On the one hand, interest rates kept crawling on the ground. The market in the post-2008 period set out a magnificent era. The stock market is set free to explore, much depends on the money supply in the market. Now, a strong suppressive force to the market has been removed. Since 2008, the effective Fed rates fell swiftly to near zero and maintained at that level for years. Before 2008, federal rates kept at a reasonable level (4%-5%) that constrained the rapid rise of the market. Before America’s massive quantitative easing, the influence of money supply on the market was relatively mild. The relation between the stock market and money supply has been established for decades. How is the Stock Market Related to Money Supply?
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