The Impact of Stock Price Index on Demand for Money in Iran

Friedman (1988) introduced Stock Price Index (SPI) as explanatory variables into the money demand function. He explained that SPI has two effect substitution and income effects on money demand. This study examines the long-run effect of stock price on demand for money by using Bounds test approach to level relationship and Granger causality test over the period of 1370:1-1386:4 (1990:1-2006:4) Bounds test results strongly confirm the existence of long-run relationship among variables in both demands for real M1 and M2 models. Moreover, our result reveals that SPI has a significant substitution effect on long-run demand for real M1 and M2. In these two definitions of money, long-run elasticity of real money demand to GDP is greater than one and long-run elasticity of real money demand to exchange rate is positive and less than one. Moreover, long-run elasticity for real money demand to inflation and SPI is negative and less than one in absolute value. In demand function for M1 and M2, one percent increase in SPI reduces the long-run real money demand about 0.015 and 0.10 percent, respectively. The inverse effect of SPI on money demand confirms the existence of substitution effect. Moreover, Granger causality test results confirms indirect one-side casualty from the set of independent variables to real M1, and M2 at 10 and 5 percent significance level in the long-run, respectively.