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

(Macquarie University) 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 ... more.

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