Relationship between Stock Prices, Exchange Rate and the Demand for Money in India

ABSTRACT.This paper investigates the relationship between stock prices, exchange rate and demand for money in India during the period of post liberalization in India. The objective of the paper is two-fold. First, the study aims to shed light on the co-integrating properties of different monetary aggregates, stock prices, exchange rate, interest rate, economic activity, and inflation in India. Specifically, the purpose is to determine whether there is a stationary long run relationship between demand for different monetary aggregates and their determinants. Secondly, the study investigates the stability of the long run money demand function with its determinants. For the analysis, monthly data from 1996:1 to 2010:8 is used. The study employs the Johansen and Juselius Co-integration (1990) approach for checking the long run integration among the variables along with VECM model. Further, Granger Causality test is carried out. The test results discloses the presence of more than two co-integrating vector for each money demand specification. The long run elasticity of demand for money reveals that money demand function is sensitive to inflation, stock prices and economic activity. Unidirectional causality is reported from stock prices and exchange rate to demand for money function.JEL Classification: C32, E41, E44, E51Keywords: demand for money, stock prices, monetary aggregates, exchange rate, co-integration, Granger Causality(ProQuest: ... denotes formulae omitted.)1. IntroductionDemand for money determination is one of the major issues in the field of monetary economics literature. The issue of demand for money has been the subject of vast empirical and theoretical investigation over the couple of decades by researchers. There are several motivations for this line of enquiry. Arguably, demand for money in simple terms is the people's desire to hold money. Demand for money has been studied in different dimensions in the past literature like determinants of demand for money and stability of demand for money over the period of time. There are different determinants identified by different economist which affects the demand for money. The determinants are output, interest rate, exchange rate, stock prices, and inflation etc. which can significantly affect the demand for money. Further the stability of demand for money implies that the quantity of money can be predictable related to various macroeconomic variables Friedman (1987). The stability of demand for money over the period is crucial for efficient monetary policy transmission. In the past various studies tried to identify the suitable determinants of demand for money and stability of demand for money which can be stable over the period for particular economy. In this context the present study examines the stable long run relationship between money demand, stock prices and exchange rate in India. Because, a consistent stable relationship between money demand and its determinants like stock prices and exchange rate is prerequisite for monitoring and targeting of monetary aggregates. The Central Bank has control over the money balance, which can affect the macroeconomic policy. The success of the monetary policy depends on whether there exists a stable relationship between money demand and its determinants.The literature on demand for money has been quite extensive both theoretically and empirically. From the theoretical perspective the early classical economist Fisher (1911) stated that real income determines the real demand for money. Theoretically high income of the people increases the transaction demand for money. Further, Keynes has assumed that there are different motives such as transaction, precautionary and speculative demand for money. According to this theory income and interest rate play a significant role for determination of demand for money. Income determines the transaction demand and interest rate determines the speculative demand for money. …