
The UK M4 money supply looks like this. Q.E. is a feature of monetary policy not some new buzz word of the recession. Obviously in a static economy if you double the amount of money in circulation then each transaction will use twice the money it did before and so the cost of everything doubles and the power of the currency halves. This is inflation.
The assumption behind increasing the money supply (Q.E.) is that the economy grows and so there are more transactions. If the economy doubled but the money stayed the same it would be the opposite of the above. Twice the transactions and so half the money would be used in each which would cause prices to halve and the power of the currency to double. This would be deflation.
Of course just having loads of cash in a bank vault doesn't make up M4. It must be in circulation which I understand is the money velocity (not being an economist - and I must stress this blog is a search for truth not an exposition of it!). The faster it moves the more transactions it can be used in and so it is more effective than money in a vault (which isn't being used as collateral against a debt that is being traded and so increases money flow by proxy obviously).
So why is inflation favoured over deflation? One argument you will hear is that an efficient pound puts pressure on other currencies so exports grind to a halt as other economies can't afford produce priced in pounds. Exports are important because they stimulate jobs, but they also stimulate the value of the currency. Take the example of the UK selling services to France. I assume this means that the French have to buy pounds on the currency markets to execute the transactions. Pound demand goes up which pushes the value higher in addition to even more transactions being executed. Imports conversely destroy local jobs and require the buyer to purchase the currency of the supplier putting the home currency into the market place and lowering its value. So to keep exports up in an economy with growing demand, the currency must be devalued by Q.E. I think this gets lost on the gold-standard fraternity.
Another argument you don't hear is that when the central bank prints money is makes money also. It buys things with the money it has printed. This is illegal for non-central banks for very obvious reasons ;-) But central banks can make money for just the cost of printing while everyone else has to do real "work" or own real "risk" to make money. I'm sure the temptation is to make a bit more than they need especially with the government pushing them to reduce the debt.
A NOTE here as I think this through: I have criticised Fractional Reserve banking before but see a bit more now. To buy a house I need some money that I haven't got. When I go to a money lender I am able to produce cash that I haven't got. The seller can actually go and get a suitcase with the £200k in it if they wish. Now in reality only a fraction of that money exists since banks lend out some 30times what they have in store, and assume that not everyone on simple probability is going to go and get a suitcase of their money at once. Pounds only represent the value in an exchange transaction not the actual value of things. The M4 is only the money in circulation not the value of the country. This is why things that aren't traded have no price - it doesn't mean they have no value! So the process of money lending is not the process of handing over the value of a house but rather entering into a complex exchange process whereby I can execute it instantly at one end and slowly at the other end through a mortgage. But the bank doesn't execute it instantly either since, in most cases, it doesn't have to produce a suitcase of cash. So it is false to think the banks are making money out of nothing by fractional reserve banking, they are simply setting up complex exchange processes that are a bit more subtle than handing things over a single counter. And anyway someone with a mortgage has just spent money they don't have and has just made money out of nothing - how else are they sitting in a house they haven't paid for yet? What this process does do is create huge inflation as argued a long time back in the blog.
Back to the point above. Rather than support inflation savers argue in favour of deflation because it means that the money they got paid yesterday is worth more today. There is less incentive to spend and so the number of transactions reduces naturally as they save which returns the value of the currency to some stable level. The built in negative-feedback device of deflation thus naturally balances that of inflation. However reducing the number of transactions reduces the amount of work in the economy which (as things are set up in current economies) will reduce the pay and so circulation of money; this might cause a downward spiral. The answer as this blog has analysed endlessly is to rethink the distribution of wealth and intelligently uncouple it from work - but that requires a re-conception of life and work (which this blog is desiring to do).
If there is a growing population then the number of transactions is going to increase naturally. With a limited money supply this will mean that less money is used in each transaction and so will lead to natural deflation. The single case where population growth leads to wealth (for a few). The deflation will lead to pressure to save, which will reduce the flow of money and cause another deflationary spiral.
There are thus very good reasons to increase the money supply to ensure that saving doesn't become too attractive. This means however that savings get hurt. To compensate, savers get an interest which is paid by borrowers. The amount that borrowers are prepared to pay depends upon their expected returns and competition between banks for lending credit. A growing economy favours lending and so interest payments. In theory the devaluation due to increase in money supply ought to be offset for savers by the increasing interest payments. However in Keynesian reality, growth is created by reducing interest payments to make credit cheap to drive borrowing and spending (the Ponzi Scheme that is the model for modern economics). Savers get little interest and then get hit by the stealth inflation in the market place, and the devaluation of their currency due to Q.E. The emphasis is on spending and debt which means we have not only today's money in our pocket but tomorrow's and the money from the day after. Massive Q.E. driving inflation. As prices go up we need to borrow more (e.g. house prices) and an inflationary spiral is entered. I imagine that eventually economist will learn to balance these forces of inflation and deflation, but at the moment, for whatever reasons, they are amateurish and incompetent.
Anyway now the point of this long foray into monetarism. The M4 money supply in the UK has increased from about £125 bill in1984 to £1400 billion in 2010. That is an increase of about 11 times. In a static economy this would result in prices increasing about 11 times. The average house price in 1984 was £75k and recently peaked at £200k so in reality an increase of only 2.6. Assuming that pressure for housing hasn't changed (not unreasonable as the population is basically the same and there has been a lot of house building in the last 26years which ought if anything to reduce prices) then house prices should have remained static which means that the economy must have expanded to take up the extra money. But still 2.6 times too much money was printed and the real economy only grew by 11.2/2.6=4.3.
A more reliable measure would be the GNP which has increased in the period from $629PPP bill to $2350PPP bill an increase of only 3.74 times. That means that 11.2/3.74=3 times too much money has been printed meaning that everything costs 3x what it should and savings are a 1/3 less powerful then they should be! This agrees with the rough measure above and supports the assumption that pressure for housing hasn't actually increased. The economy has actually only increased by a factor of 3.74 instead of 11.2 while the pound has actually weakened to a third and prices are 3 times what they were. That was the basis of the "apparent" booms that Brown and others have resided over.
So now back to stock markets. If you invested £1000 in the stock market in 1984 with economic growth of 3.74 it should be worth £3740 today (assuming your companies expand in accordance with the general economic growth). However M4 money printing has been going on. If it was in line with the 3.74 growth then the pound would remain stable and you would have £3640 today. But we know that 11.2 times as much has been printed (3 times too much) so actually the buying power of the pound has reduced to a 1/3. So the £3740 we see on the balance sheet is really only worth 1247 (in 1984 pounds). That is an actual increase of 125% in 26 years that is just 0.86% per year. Put that another way we need to make 26root(3)= 4.3% a year to keep up with the excessive money printing.
The relevance of this to the stock modelling is that an upward trend of 4.3% a year is present not because of anything in the stock market but because of the devaluation of the currency. This is maybe enough to turn a lot of down moves into up moves and bias what is perhaps a random pattern. Removing this up-trend might also make modelling the distributions easier. A new dataset removing the M4/GNP data is required.
Here is data from http://www.marketoracle.co.uk/Article24619.html

Since 1987 the value of the pound based on the RPI has dropped to 44%. Extrapolate backwards to 1984 and that is 35% similar to the 33% above.
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Here is the UK treasury data on GDP and also inflation.
£100 in 2009 is the equivalent of £42 in 1984. That is substantially higher than the 33% above but will do to begin with.
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