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Money and Stock Prices

An important factor regarding the movement of stock prices is the money supply. In
general fluctuations in money supply are the key to stock price movements. For
example, if the FED increases the money supply consumers have more money which
they can spend on stocks leading to a higher demand for stocks which results in a
higher average stock price. The other direction works too, if the money supply
decreases consumers have less money to spend resulting in a lower demand and
lower average stock prices. Contrary to that theory the reality is often different. The
reason for that is that there are too many other influences like business expectations,
political developments or a spurt in consumer spending. Furthermore, the FED often
changes the money supply accompanied by other economic events. Therefore, it is
hard to identify the real impact of money supply on stock prices. Overall monetary
policies can influence stock prices by impacting money supply, interest rates,
financial markets, current and expected business conditions and the expected rate of
inflation.
Bubbles and the Stock Market
Another explanation for swings in stock prices are bubbles. A bubble occurs when
the asset price differs from the fundamental value of the stock meaning that
investors believe that other market forces besides future dividend payments and
interest rates become more important in the future. The bubble continues to grow,
leading to rising stock prices making people reluctant to sell and encouraged to buy.
When the bubble bursts due to some event the prices fall and holders sell their
stocks. The impact of such a bursting bubble can be seen by the real estate bubble in
the US in 2007/08. Bubbles are problematic because they are hard to identify since
the real fundamental value of a stock is based on future level of dividends and riskadjusted interest rates, which are both unknown.
To prevent bubbles and stock speculations the FED can implement a margin
requirement on stock purchases. The margin defines how much of an investment can
be borrowed and how much has to come from a security paid with cash. The higher
the margin requirement, the less probable are speculations and the emergence of
bubbles.
Foreign exchange
A foreign exchange is a transaction between residents of different countries. It is
made on the foreign exchange market, a network of foreign exchange dealers e.g.
banks. Those dealers buy and sell foreign monies in form of foreign currencies and
deposits. The rate at which the currencies are traded is the foreign exchange rate. It
is important because it affects the relative price of domestic and foreign goods and
services. There are two types of exchanges, one is a spot transaction. It means an
immediate exchange of bank deposits leading to the spot-exchange rate. The other
one is a forward transaction, an exchange of bank deposits at a specified future date
resulting in the forward-exchange rate. Most commonly known reasons for
exchanging currency are travelling tourists or the export/import of products. Usually
foreign goods have to be paid in foreign currency, as a result the foreign currency has
to be acquired first by entering the foreign exchange market and exchanging the
respective domestic currency amount for the needed foreign currency amount.
In general, the foreign exchange rate is determined by demand and supply. When
inhabitants of country A import foreign goods, buy foreign stocks or travel abroad
they need foreign currency to carry out those actions. As a result, the demand for
foreign currency (B) rises, while at the same time the supply of currency A rises, too.
On the opposite, if country A exports goods, sells securities to foreigners (B) or hosts
travelling foreigners the demand for currency A rises as well as the supply of
currency B. These demands and supplies are summarized in the national balance of
payments. It consists of the current account (international transactions that involve

currently produced goods and services) and the capital account (international
transactions involving assets like stocks and bonds).
Two important terms regarding the foreign exchange rate are currency appreciation
and depreciation. Appreciation of currency A means that the price that foreigners (B)
have to pay for currency A rises. At the same time currency B depreciates, meaning
that foreigners (A) have to pay less for currency B. The reason for an appreciation of
currency A and depreciation of currency B is that currency A is more demanded in
country B than currency B in country A. This relies on the simple economic
understanding that a high demand leads to high prices while a low demand leads to
low prices. This relation of prices and demand and supply leads to self-correcting
changes of the foreign exchange rate. In case of an appreciation of currency A goods
of country A get more expansive compared to products of country B. This leads to a
lower demand for products of country A, leading to a lower demand of currency A. As
a result currency A is likely to depreciate with respect to currency B. Contrary, when
currency B depreciates, goods produced in country B get less expansive compared to
goods of country A. This leads to an increased demand for Bs products, increasing
the demand for Bs currency, resulting in an appreciation of currency B.
However, the demand and supply based equilibrium is only short-term. As soon as
the curves shift, the equilibrium exchange rate will shift, too. There are three main
reasons for shifting curves. First, a change in the relative price of country As vs.
country Bs goods. If in country A the overall price level rises inhabitants will export
more from country B, leading to a depreciation of currency A respective currency B. A
reason for rising price levels are that As rate of inflation exceeds Bs rate of inflation.
Second, if A increases its productivity it will be able to produce and sell products
cheaper. These lower prices lead to a high demand for As products resulting in As
currency appreciation. Third, when consumers shift their taste from country As
products to Bs products the demand for currency B rises and A depreciates with
respect to B. These three factors change rather slowly over time.
The daily exchange rate volatility is mainly caused by actions of global investors.
When making a decision where to invest they compare the expected return on
domestic securities with the expected return on foreign securities. As a result, they
either follow a domestic or foreign strategy. A domestic strategy is less risky. The
reason for that is that when the investor wants to buy a foreign security he has to
pay it with foreign currency. And when the investment terminates e.g. after a year,
the investor has to convert the gained currency back to his domestic currency. In
case of an uncovered interest rate parity (compared to a covered interest rate parity
which means agreeing on a future exchange rate) the investor can only guess the
future exchange rate. As a result, to gain more compared to a domestic investment
the interest rate of the foreign investment has to exceed the interest rate of a
domestic investment by an amount equal to the expected appreciation of the
domestic currency. Overall the most important influence when deciding on a foreign
vs a domestic investment is the expectation whether the domestic currency will
appreciate or depreciate regarding the foreign currency. As a result, todays
exchange rate is sensitive to investors expectation of future exchange rates because
it influences todays demand for foreign currency.
Exchange rates can be either fixed or floating. A fixed exchange rates means that the
price of currency A expressed in currency B is set at a fixed level. The reason to make
this decision is to stop floating exchange rates and provide a greater certainty.
However, fixed exchange rates can be problematic. When a currency set at a fixed
exchange rate starts to depreciate the country will have to buy their own excess
currency to stop the depreciation. For this the country has to use their international
reserves e.g. gold, US $ or (a currency that is not their own). Once the reserves are
empty the currency has to be devalued to represent its current, less than before
value. Another problem is if people expect the devaluation of a currency they start to
sell it, increasing the depreciation which makes the devaluation even more probable.

On the opposite there are floating exchange rates. A floating exchange rate is based
on depreciation and appreciation leading to an equilibrium exchange rates between
two currencies. In addition, many consider nowadays exchange rates as managed
floating exchange rates which means that it is a floating exchange rates but
influenced managed by FED regulations.