Money and equity returns in the Euro area

This study examines the impacts of liquidity on equity returns in the euro area during the period 1987-2001. The main contribution of the study is that the money demand is carefully considered while estimating the liquidity. We provide evidence that in part the impact of money on equity returns depended on the measure used for liquidity (real money supply, real money gap and monetary overhang). However, a unanimous inference was made that over time an increase in liquidity has a negative impact on equity returns. This is interpreted as being due to the positive impact of money on inflation. Accordingly, an increase in liquidity generated expectations of inflation, which led to a decrease in aggregate supply. Lower output, in turn, produced a lower dividend yield, which decreased equity prices. The results indicate that liquidity also has some predictive power for equity returns for periods exceeding three quarters.