Abstract

This paper investigates the possible impact of changes in the US Money Supply (M2) levels on the Canadian stock market using the S&P/TSX Composite index as a proxy. The techniques employed are the error correction and variance decompositions techniques including ‘long-run structural modelling (LRSM)’ (Pesaran & Shin, 2002), which has addressed the major shortcomings of the conventional cointegrating estimates by imposing exactly identifying and overidentifying restrictions on the cointegrating vector. The CUSUM and CUSUMSQ tests have been applied to test the stability of the coefficients. To the best of our knowledge, no research on this issue has been done using techniques that incorporate LRSM. Our findings indicate that shocks to the US money supply M2 have a significant cross-country positive impact on the prices of the S&P/TSX composite index, and that there is a long-run relationship between these two variables. Both the error-correction model and the variance decomposition analysis applied in this paper tend to indicate that the US Money Supply M2 variable leads the S&P/TSX composite index. These findings are of a significant importance to Canadian investors and portfolio managers on one hand as shocks to the US Money Supply (M2) are most likely to impact their portfolio investment; and to Canadian policy makers on the other hand as they can monitor the changes in the US Money Supply (M2) and adopt appropriate policies accordingly in order to absorb the spillover of the US monetary policy and help their stock market return to long-term equilibrium.

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