M1, M2, and the U.S. Equity Exchanges

We study the relative positions of M1 and M2 in light of their relationships with four U. S. equity exchanges: S&P500, Dow Jones Industrial, Nasdaq, and Wilshire 5000 composite. It is demonstrated that a long-term equilibrium relationship does indeed exist. Short-run dynamics are also considered and are found to be temporary departures from the long-run equilibrium. Based on a model, which yields robust estimated results and is thus considered well behaved, the direction of causality is established. The model is then put further to test to check the predictive power of the M1 and M2 money aggregates. Based on a set of in- and out-of-sample forecast experiments, the results overwhelmingly indicate that M2 is a better predictive measure and hence a superior indicator than M1. The policy implications of these findings in light of the post financial crisis and the November 2010 US Fed “quantitative easing” policies are discussed.