Do stock prices play a significant role in formulating monetary policy? a case study

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.