Since the end of February when the S&P 500 closed at 735.09, the index has been pushing strongly ahead, closing on Friday, May 8, at 929.23 an increase of 26.4%. We suggest that the key driving force behind this strong bounce is a massive increase in liquidity. What is it all about, and how do changes in liquidity drive the stock market?
In a market economy, a major service that money provides is that of the medium of exchange. Producers exchange their goods for money and then exchange money for other goods.
The increase of production of goods and services results in a greater demand for the services of the medium of exchange (the service that money provides). Conversely, as economic activity slows down, the demand for the services of money follows suit.
The demand for the services of the medium of exchange is also affected by changes in prices. An increase in the prices of goods and services leads to an increase in the demand for the medium of exchange. People now demand more money to facilitate more expensive goods and services.
A fall in the prices of goods and services results in a decline in the demand for the medium of exchange.
Now, take the example where an increase in the supply of money for a given state of economic activity has taken place. Since there wasn’t any change in the demand for the services of the medium of exchange, this means that people now have a surplus of money or an increase in monetary liquidity.
Obviously, no individual wants to hold more money than is required. An individual can get rid of surplus cash by exchanging the money for goods.
All the individuals as a group, however, cannot get rid of the surplus of money just like that. They can only shift money from one individual to another individual.
The mechanism that generates the elimination of the surplus of cash is the increase in the prices of goods. Once individuals start to employ the surplus cash in acquiring goods, this pushes prices higher.
As a result, the demand for the services of money increases. All this in turn works towards the elimination of the monetary surplus.
Once money enters a particular market, more money is now paid for a product in that market. Or we can say that the price of a good in this market has now gone up. (Remember a price is the number of dollars per unit of something.)
Note that what has triggered increases in the prices of goods in various markets is the increase in the monetary surplus or monetary liquidity in response to the increase in the money supply.
While increases in the money supply result in a monetary surplus, a fall in the money supply for a given level of economic activity leads to a monetary deficit. Individuals still demand the same amount of the services of the medium of exchange. To accommodate this, they will start selling goods, thus pushing their prices down.
At the lower prices the demand for the services of the medium of exchange declines and this in turn works toward the elimination of the monetary deficit.
A change in liquidity or the monetary surplus can also take place in response to changes in economic activity and changes in prices. For instance, an increase in liquidity can emerge for a given stock of money and a decline in economic activity.
A fall in economic activity means that fewer goods are now produced. This means that fewer goods are going to be exchanged, implying a decline in the demand for the services of money the services of the medium of exchange.
Once, however, a surplus of money emerges, it produces exactly the same outcome with respect to the prices of goods and services as the increase in money supply does, i.e., it pushes prices higher. An increase in prices in turn works towards the elimination of the surplus of money the elimination of monetary liquidity.
Conversely an increase in economic activity while the stock of money stays unchanged produces a monetary deficit. This in turn sets in motion the selling of goods thereby depressing their prices. The fall in prices in turn works towards the elimination of the monetary deficit.
There is a time lag between changes in liquidity, i.e., a monetary surplus and changes in asset prices, such as the prices of stocks.
For instance, there could be a long time lag between the peak in liquidity and the peak in the stock market. The effect of previously rising liquidity could continue to dominate the effect of currently falling liquidity for some period of time. Hence the peak in the stock market emerges once the declining liquidity is starting to dominate the scene.
(The reason for the lag is because when money is injected it doesn’t affect all the individuals and hence all the markets instantly. There are earlier and later recipients of money.)
Exploring how changes in liquidity had historically been driving the stock market.
For instance, the yearly rate of growth of our monetary measure AMS stood at 4.1% in March 1974 and 4.5% in May the following year. Despite the relative stable money-supply rate of growth, the yearly rate of growth of monetary surplus had a large increase from negative 7.7% in March 1974 to a positive figure of 7.6% in May 1975.
May 13, 2009