Money supply endogeneity and bank stock returns: empirical evidence from the G-7 countries

  • Zatul Badarudin

Student thesis: Doctoral Thesis


This thesis is about (a) money supply being determined by banking behaviour, or by the behaviour of central banks and (b) the influence of money supply on bank stock returns. That money is endogenously determined is a proposition of post Keynesian (PK) economists suggesting that money supply is determined by the behaviour of commercial banks as banks adjust money creation in response to credit demands by the public. This theory challenges the monetarist view of exogenous money supply, where the central bank is said to control money supply. This thesis examines how, under the credit-creation behaviour of banks, the money supply affects bank stock returns in a multi-equation model. The theory of endogenous money is founded on the idea that loans made by banks cause deposits, and that deposits in banks, as a component of money supply, thus create more money supply. In the process, due to the changes in loans and deposits experienced by banks, the stock returns of banks may also be affected, since banks’ profit margins are affected by the changes in credits. Whether endogeneity is in fact the way the money supply behaves has not yet been widely tested and there is also not yet any published study on the behaviour of aggregate bank stock prices in relation to money supply changes. Hence, the aim of this thesis is to provide new findings on this unexplored relationship between endogenous money supply and bank stock returns by testing this proposition across several key economies over a long period, taking into account the actual monetary policy regimes in place in these economies. The empirical evidence in this thesis is obtained by using quarterly data from 1973 to 2007 for the G-7 countries: Canada, France, Germany, Italy, Japan, the United Kingdom (UK) and the United States (US). As the data series covering the sample is over a long period, important monetary-policy regime changes – especially in Canada, the UK and the US – are considered and used in the empirical tests of the underlying hypotheses. The empirical tests conducted begin with unit root and Johansen cointegration tests to test for stationarity of the variables and whether the variables are cointegrated, followed by vector error-correction models (VECM) and Granger causality tests to test whether there is one-way or bidirectional causality in the long run and in the short run. These tests are used to determine (1) whether money is endogenous or exogenous, (2) if money is endogenous, which of the three views of PK theory is supported in this study, and (3) whether there exists a relationship between money supply and bank stock returns. Trivariate VAR tests developed by Toda and Yamamoto (1995) are used to test whether deposits are an important variable in the causality between bank loans and money supply. Later, a simultaneous equation model is developed to explore the possible simultaneous relationship between aggregate bank stock returns and money supply, and money supply and bank loans. This model is tested using Generalised Method of Moments (GMM) panel data estimation as proposed by Arellano and Bond (1991). Prior to the model estimation, panel unit root tests are applied following procedures provided in Maddala and Wu (1999) and Choi (2001) to test for stationarity in the variables; Pedroni (1997) panel cointegration is performed to establish whether the variables are cointegrated. VECM and Granger causality tests are also employed to determine whether there is causality between the variables in the equations. The results of this thesis provide several important new and useful leads. Firstly, bank loans are found to cause money supply; bidirectional causality exists between bank loans and money supply, suggesting that money is endogenous (except for two cases). Secondly, for the countries where money is found to be endogenous, there is mixed evidence as to which of the three views are supported by the test results – accommodationist, structuralist or liquidity preference. Mainly the structuralist and liquidity preference views were supported for Canada (1976:3 to 1990:4), France, Germany, Japan, the UK (1992:4 to 2006:2), and the US. Thirdly, the results indicate that there is a difference between long-term and short-term causality – for example, where there is support for structuralist or liquidity preference in the long run, evidence is in support of the accommodationist view in the short run, as in the cases of Japan, Canada (1976:3 to 1990:4) and the US (1987:1 to 2007:1). Fourthly, as indicated by the robust results of the trivariate VAR tests, bank deposits are found to be a significant variable in all samples except those of Canada (1991:1 to 2007:1) and Italy. Fifthly, it is found that with the exception of US (over 1975:3 to 1986:4), there is a relationship between money supply and bank stock returns. The US has the most competitive banking system. Finally, the findings using the panel data estimation show that there is a positive relationship from money supply growth to growth of bank stock returns, but negative from the growth of bank stock returns to money supply growth. This may be explained through the central bank changing interest rates with the aim of negating inflation. This action leads to a rise in interest rates and subsequently to reduced money supply. It was also found, in this context, that there is a bidirectional positive relationship between bank loan growth and money supply growth, which supports the PK theory of endogenous money. Thus, the money-to-bank-stock-returns relation is founded on money being endogenous, meaning that bank credit creation is the source of the effect of the money supply on bank stock returns. The money supply to bank stock returns were tested for robustness using three different tests. All tests provided confirmation of the relationship (except for the US). Apart from the very important empirical evidence that the thesis brings to bear on this new PK theory for a group of seven key developed economies, the findings of the thesis have important implications as to the key functioning of a banking system. Banks are not only transmitters of monetary policy but are also important in the development of the growth of money through loan creation to the money supply and bank stock price formation.
Date of Award6 Jun 2009
Original languageEnglish
SupervisorAhmed Khalid (Supervisor) & Mohamed Ariff (Supervisor)

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