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Do Stock Prices Play a Significant Role in Formulating Monetary Policy? A Case Study

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  • Masih, Mansur

    ()
    (King Fahd University of Petroleum and Minerals)

  • De Mello, Lurion

    ()
    (Macquarie University)

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    Abstract

    The recent fluctuations in stock prices around the world and the critical place that the demand function for money holds in the formulation of a country’s monetary policy motivated us to investigate the question as to whether real stock prices play any significant role in affecting the demand for money and hence monetary policy. Using Australia as a case study we subject the Australian money demand function (containing real money, interest rates, real income, and real stock prices) to a rigorous econometric scrutiny. The methods applied extend the well established cointegration and error-correction framework by analyzing the out of sample properties via generalized variance decompositions, generalized impulse response and persistence profile functions. We also apply the most recently developed technique of ‘long run structural modelling’ (Pesaran and Shin, Econometric Reviews, 2002) which by imposing exactly identifying and overidentifying restrictions on the cointegrating vector has taken care of a major limitation of the conventional cointegrating estimates in that they were atheoretical in nature. We investigate the positive income effects and negative substitution effects of stock prices on money by using short and long form of interest rates together with a narrow and broad definition of money. Our results tend to indicate that stock prices do play a significant role in the money demand function. A clear policy implication is that a failure to incorporate real stock prices in the money demand function may result in the function being unstable and the monetary policy being far less effective.

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    Bibliographic Info

    Article provided by Camera di Commercio di Genova in its journal Economia Internazionale / International Economics.

    Volume (Year): 62 (2009)
    Issue (Month): 2 ()
    Pages: 203-232

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    Handle: RePEc:ris:ecoint:0010

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    Keywords: Money Demand; Stock Prices; Cointegration; Long Run Structural Modelling;

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    1. Denis Kwiatkowski & Peter C.B. Phillips & Peter Schmidt, 1991. "Testing the Null Hypothesis of Stationarity Against the Alternative of a Unit Root: How Sure Are We That Economic Time Series Have a Unit Root?," Cowles Foundation Discussion Papers 979, Cowles Foundation for Research in Economics, Yale University.
    2. John B. Carlson & Dennis L. Hoffman & Benjamin D. Keen & Robert H. Rasche, 1999. "Results of a study of the stability of cointegrating relations comprised of broad monetary aggregates," Working Paper 9917, Federal Reserve Bank of Cleveland.
    3. Koop, Gary & Pesaran, M. Hashem & Potter, Simon M., 1996. "Impulse response analysis in nonlinear multivariate models," Journal of Econometrics, Elsevier, vol. 74(1), pages 119-147, September.
    4. Pesaran, M.H. & Shin, Y., 1993. "Cointegration and Speed of Convergence to Equilibrium," Cambridge Working Papers in Economics 9311, Faculty of Economics, University of Cambridge.
    5. DeJong, David N, et al, 1992. "Integration versus Trend Stationarity in Time Series," Econometrica, Econometric Society, vol. 60(2), pages 423-33, March.
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