In a recent post, Paul Krugman rejected calls for monetary tightening
as a way to deflate a supposed bubble in stock prices. It will come as no surprise to anyone that
asset bubbles are the side effect of an active Fed. Understanding how Fed policy causes asset bubbles holds the
key to the question at hand: are we in a
stock bubble with the S&P 500 Index hitting 1,800 or does this bull market have real
legs?
Here is an interesting chart that compares the S&P 500 Index with changes in US money demand (Ma).
What is money demand? This is the money people stuff in their mattresses or hoard as bank deposits and money market funds. The demand for money is the most important macro-economic monetary variable because unlike the supply of money, it is not subject to direct manipulation by the Federal Reserve. Rather, it is corporations and individuals who choose what to do with their money.