Central Bank Money Supply:A 15 percent increase in money supply represents central bank monetary stimulation. Such stimulation should foster stronger economic growth (positive equity impact). However, bond yields could be expected to increase because monetary stimulation may increase expectations for higher aggregate growth and because of the potential higher inflation that monetary stimulation can cause over time (negative corporate bond impact).
if such a question appears, should we look at it from new investment perspective or effect on existing investment?
I never really agreed with the economic theory behind money supply = more economic growth, because the theory looks at a poor representation of economic growth, the amount of loans than happen in the market and doesn’t consider negative externalities.
anyways, for the exam: monetary stimulus = more banks loaning out to businesses (think QE) = more company projects get funded = more growth. printing more dollars = a dilution of the value of the dollar = inflation.
growth and inflation expectations will (according to thier theory, should) go up
Existing bond prices will decline (basically for the exam ignore everything that you have read about QE and the current bond markets)
Stocks act as a partial inflation hedge (if they can pass it on to consumers in product prices) and will benefit from expected economic growth and will go up in price.
I am reopening this topic because I worked on this question today and I had the same issue.
I understand the point about the inflation, but at first, I answered the contrary: that the impact of increased central bank money supply was positive on the corporate fixed-income market.
Why? Because increase of money supply (versus demand) -> decrease in the yield -> increase in the bond price.
It’s a little broad what increasing the money supply actually means.
If we assume traditional monetary stimulation, then a decrease of interest rates, required reserves, or open market operations on short-term treasury bills will steep the yield curve, because the central bank is artifically depressing short term real interest rates, but not long term interest rates. The yield curve as a whole shifts down however, as the lower ST rates pull down longer term rates due to the arbitrage free yield curve model (controlling for market sentiment). The second effect is inflation, since an increase in money supply in the economy means more money lent out, there is potential to drive up inflation as the aggregate demand outpaces aggregate supply, whereby higher expectations of inflation outweighs the smaller drop in longer term real interest rates, and may outweigh the improvement in default spreads for a corporation if the cheaper financing does not significantly improve its financial condition.
It’s a dynamic model where all possibilites exist, there is no one right answer depending on the assumptions you use.
Sorry, I am trying to understand your reasoning but I will have to break it down because I am really not an economist and this is one of the toughest parts of the CFA for me.
Here I read “increase in money supply” -> “demand outpaces supply”. I would have concluded the contrary. What am I missing please?
Real demand outpaces real supply, not money supply. To offset this, prices go up to bring back demand and supply into equilibrium.
Dilution of the monetary base should increase prices if that money is used in the economy. Inflation means more money chasing goods, so prices go up to clear the market.
Thanks I understand what you say. Not meaning that I get the big picture yet, because I envisage all the effects and I always have a hard time seing which effect is the most meaningful and offsets potential contradictory other effects, but I will get used with time. Get ready to get more questions from me on that topic
