Chung T and Ariff M
Prior studies that have examined the drivers of stock returns have mostly focussed on firm-specific factors. However, King demonstrated that firm-specific factors explain only 38% of the variation in stock prices, while the dominant driver was macroeconomic factors (52%) with industry-related factors accounting for the remaining 10% of stock price variation. Against this background, the present study, to our knowledge, is the first attempt to model Friedman's still-unproven money-supply led banking liquidity effect and the subsequent effect on stock prices, that will be represented as stock index returns in this study. We, thereafter, proceed to build a model to connect money supply and banking liquidity to overall stock index returns. For the purpose, we apply a system of equations, and use quarterly macroeconomic data series of G-4 countries (Canada, Japan, the UK, and the US) covering a 54-year period. We control for monetary regime changes such as a shift from monetary targeting to inflation targeting, structural breaks following the global financial crisis (GFC) and monetary policy changes. To test robustness of our findings, we provide causality tests linking money supply to liquidity as well as stock index returns and earnings before applying bootstrapping method to refine the parameter estimates.
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