Middle Eastern Finance and Economics

ISSN: 1450-2889 Issue 3 (2009)

© EuroJournals Publishing, Inc. 2009
http://www.eurojournals.com/MEFE.htm

Relationship between Stock Prices, Exchange Rate and Demand

for Money in Pakistan

Qazi Muhammad Adnan Hye

M.Phil Student; Applied Economics Research Centre
University of Karachi, Karachi
E-mail: adnan.ecnomist@yahoo.com

Syed Khurram Arslan Wasti

M.Phil Student; Applied Economics Research Centre
University of Karachi, Karachi
E-mail: arslan_bzu@hotmail.com

Narjis Khatoon
M.Phil Student; Applied Economics Research Centre
University of Karachi, Karachi
E-mail: rizvi.narjis@yahoo.com

Kashif Imran
M.Phil Student; Applied Economics Research Centre
University of Karachi, Karachi
E-mail: k.imran_aerc@yahoo.com

Abstract

In this paper, we use the robust time series tools in order to estimate Pakistan’s
money demand function for the period 1971:1-2006:4.We find that there are four co-
integrating vectors in money demand, interest rate, economic activity, inflation, stock
prices and exchange rate. Important findings of this paper i.e. stock price have positively
and statistically significant wealth effect and exchange rate insignificantly effect on money
demand in the long run. But in the short run the inflation has negative and significant effect
on money demand.

Keywords: Money Demand, Stock prices, FMOLS, Pakistan.

JEL Classification Codes: E3, G12, C1

1. Introduction
According to Friedman (1988) increase in the stock prices have two effects on demand for money,
positive wealth effect and negative substitution effect. Positive wealth effect due to the three factors (i)
the increase in nominal wealth (ii) an increase in expected return in the risky assets relative to the safe
assets which induces the economic agents to hold larger amounts of safe assets, such as money (iii) an
induced rise in the volume of financial transactions which will require higher money balances to
facilitate them. On the other hand negative substitution effect of real stock prices on money demand
Middle Eastern Finance and Economics - Issue 3 (2009) 90

implies that, as stock prices rise, equities become more attractive when compared to other components
in a portfolio; thus there may be a shift from money to stocks. The information about the factors
causing the demand for money is important for conducting a fruitful monetary policy. A stable and
well-specified money demand function is essential for statistical interpretation, forecasting, and for the
policy analysis. So, if dominates the positive wealth effect of an increase in stock prices, then higher
stock prices imply that the monetary authorities can allow faster monetary growth to achieve a given
nominal income or inflation target to avoid the target being undershot .On the contrary, if the
substitution effect dominates, higher stock prices imply the need to tighten monetary policy. Friedman
(1988) and Mc-Cornac (1991) estimated the direct relationship between money demand and stock
prices in U.S.A and Japan, found positive and substitution effect. Gerdesmerier (1996) estimated the
demand for money function in Germany, included equity holdings indirectly as part of household
wealth and found positive wealth effect on the demand for money. Choudhry (1996) estimate the
money demand function, by using the co-integration and error correction modeling approach in the
U.S.A and Canada, his findings shows that stock prices play a significant role in real M1 and M2
money balance. John Thornton (1998) estimate the long run money demand for Germany by using JJ
Co-integration technique found that real stock price have a significant and positive wealth effect on
the long run demand for real M1 balance. Baharumshah (2004) study the demand for money function
for Malaysia, using the multivariate co-integration and error correction model and found Stock prices
have a significant negative substitution effect on long-run as well as short-run broad-money demand
(M2). Yu Hsing (2007) using the Box-Cox model and the Newey-West method, estimate the money
demand function for Poland. He concludes that the stock prices cannot determine the demand for
money function in Poland. Yu Hsing(2007) estimate the money demand function for Slovakia’s , his
findings shows that the stock prices insignificantly effect the money balance (M2).
Like other countries, in case of developing economy like Pakistan researchers have ample effort
made in estimating money demand functions . Akhtar (1974), Abe, et al. (1975), Burney and Akmal
(1990), Khan (1980, 1982a) and Raza (1989) , Mangla (1979) and Nisar and Aslam (1983).Bahmani-
Oskooee and Malixi (1991) estimate the demand for money (M1) in Pakistan on the inflation rate, real
output and the exchange rate. .Rehman (2005) found that the demand for money (M2) in Pakistan has a
positive relationship with real output and the exchange rate, and a negative relationship with the
inflation rate and the demand for money would increase as the rupee depreciates or that the wealth
effect dominates the substation effect. Qayyum (2005), estimate demand for money function (M2),
employing the co-integration and error correction approach and concludes that the money demand
function (with M2 money balance) stable for Pakistan. . Zakir Hussain et.al (2006) find that no co-
integration and no-unit root in the demand for money function, regression analysis was performing by
using the OLSQ method. Yu Hsing (2007) estimates the money demand function by using the linear,
log linear and Box-Cox transformation and concludes that log linear transformation best. Demand for
money positive related with GDP, currency appreciation and negatively related by domestic interest
rate and foreign interest rate.
The objective of this research is to evaluate the impact of stock prices and exchange rate on the
demand for money function in developing economy like Pakistan by employing the JJ co-integration
and FMOLS methods. The rest of the paper planned as follows: Section-2 represent empirical data,
model and methodology use in the study.Section-3 represent the empirical result and final section
represent the conclusion and policy implication.

2. Data, Model and Econometrics Methodology

The data is used in this study, consist of quarterly observation on broad money supply (M2), economic
activity (proxy by GDP), stock prices(stock price index) , call money rate, exchange rate (Rupees per
US Dollar) and inflation ( CPI ).The time series quarterly data has collected from the International
91 Middle Eastern Finance and Economics - Issue 3 (2009)

Financial Statistics ( IFS ), but the quarterly GDP data not available in IFS. So, quarterly data is taken
from Farooq Arby publication 1.

Model
This study implements the following money demand function for Pakistan.
M t = α 0 + α 1Yt + α 2π t + α 3 ERt + α 4 Rt + α 5 SPt + ν t
(1)

Where
M t = Money demand
Yt = Economic activity
π t = Inflation
ERt = Exchange rate
Rt = Interest rate
SPt = Stock prices
ν t = Error term
The demand for money is expected positive relationship with economic activity and a
negative relationship with the opportunity cost variable (interest rate). Stock prices may reduce
or increase the demand for money due to substitution effect or the wealth effect2.Appreciation
of exchange rate may increase or reduce the demand for money due to the substitution effect
or the wealth effect3.
All variables are used in natural logarithms form in the context of small developing economy
like Pakistan. Ehrlich (1977) and Layson (1983) were argued on theoretical and empirical grounds that
the log-linear function superior to the linear function. Both Cameron (1994) and Ehrlich (1996) were
suggested that a log-linear function more likely to find evidence of a restraint effect than a linear
function. So the natural logarithms transform model i.e.
(2)
Ln( M ) t = α 0 + α 1 Ln(Y ) t + α 2 Ln(π ) t + α 3 Ln( ER) t + α 4 Ln( R) t + α 5 Ln( SP) t + ν t −

Econometric Methodology
ADF Unit Root Test
The Augmented Dickey and Fuller (ADF) (1979, 1981) test is based on the following regression
model:
ρ
ΔX t = C + βX t −1 + λT + ∑ γ j ΔX t − j + ε t − (3)
j =1

Eq (3) tests for a unit root in X t , where X consists of each of the six variables in our model, t =
1,.....,T is an index of time, ΔX t − j is the lagged first differences to accommodate serial correlation in
the errors, ε t .Eq.3 tests the null of a unit root against a trend stationary alternative. The null and the
alternate hypotheses for a unit root in X t are: H 0 : β = 0 and H 0 : β < 0 . To select the lag length
( ρ ) we use the Akaike Information Criterion (AIC) and Schwartz Bayesian Criterion (SBC).

1
All index is used in this study has based on the year 2000 =100
2
See: Friedman (1988);Fase and Winder (1998).
3
See: Arango and Nadiri (1981); Mckinnon (1982); Bahmani-oskooee and Techaratanachai (2001) ; Bahmani-oskooee and Ng (2002)
Middle Eastern Finance and Economics - Issue 3 (2009) 92

Fully Modified Ordinary Least Square (FMOLS)

When order of integration is decides than for the long run elasiticities, utilize the FMOLS method.
FMOLS was originally designed first time by [Philips and Hansen, (1990); Pedroni, (1995, 2000); and,
Philips and Moon, (1999)] to provide optimal estimates of Co-integration regressions (Bum and Jeon,
2005). This technique employs kernal estimators of the Nuisance parameters that affect the asymptotic
distribution of the OLS estimator. In order to achieve asymptotic efficiency, this technique modifies
least squares to account for serial correlation effects and test for the endogeneity in the regressors that
result from the existence of a Co-integrating Relationships 4. Although this non-parametric approach is
an elegant way to deal with nuisance parameters, it may be problematic especially in fairly very small
samples. To apply the FMOLS for estimating long-run parameters, the condition that there exists a Co-
integration relation between a set of I(1) variables is satisfied. There fore we have to confirm the
presence of the unit root and test the Co-integrating relation. Standard tests of the presence of the unit
root based on the work of Augmented Dicky Fuller (1979, 1981) used to investigate the degree of
integration of concerned variables.
Engle and Granger (1987) discussed that, a set of economic series is not stationary, there may
have to exist some linear combination of the variables that is stationary. Now, when all the variables
are non-stationary at their level but stationary in their 1st difference, this allows proceeding further for
the implementation of Johansen co-integration technique. Economically speaking, two variables will
be co-integrated if they have a long-term relationship between them. Thus, co-integration of two series
suggest that there is a long integration tests and of course, the system approach developed by Johansen
(1991,1995) can also applied to a set of variables containing possibly a mixture of I(0) and I(1)
[Pesaran and Pesaran, (1997) and Pesaran et al., (2001, p.315)]. The general form of the vector error
correction model is as follows:
p −1
Z t = ∑ψZ t −1 + α o + η t
i =1

This can also be written in standard form as:

p −1
ΔZ t = ∑ Π i ΔZ t − k − ∂Z t − k + α 1 + ε t (4)
i =1

Where;
∏ i = − I + ∂ 1 + ∂ 2 + ...... + ∂ t
i = 1,2,3,...k − 1 and ∂ = I − ∂ 1 − ∂ 2 − ....∂ k
Where p represents total number of variables considered in the model. The matrix ∏ captures
the long run relationship between the p-variables. Now for the Johansson Test; we employed the Trace
test, which is based on the evaluation of H o (r − 1) against the null hypothesis of H o (r ) , where r
indicates number of co-integrating vectors. The co-integration test provides an analytical statistical
framework for investigating the long run relationship between economic variables in the model.
Johansen and Juselius (1990) provide critical values for the two statistics. The statistical distribution
depends on the number of non-stationary components and model telling of constant and trend term. To
determine the non-stationary components, it is necessary to choose the lag length for VAR portion of
the model. To overcome this problem, this work determines the optimal lag length using Akaike
Information Criterion (AIC) and Schwartz Bayesian Criterion (SBC) 5. The lowest values of AIC and
SBC to select the lags give the most desirable results.

4
See Philip and Hansen (1990), Hansen (1995) for details.
5
The distribution of test statistic is sensitive to the order of lag used. If the lag order is used less than true lag, then the
regression estimates will be biased and residual term will be serially correlated. If the order of lag used exceeds the true
order, the power of the test is to be reduced.
93 Middle Eastern Finance and Economics - Issue 3 (2009)

3. Empirical Result
In this section we analyze time series properties of the data during the period 1971:1-2006:4.The ADF
tests result (Table-1) shows that the existence of unit root all the six variables that are included in the
model. However, the first differences of these variables are stationary under the test. Hence, we
conclude that these six variables are integrated of order 1 or I(1).

Table 1: ADF Unit root Test Results

Variables Level First Difference

Ln (SP) -2.377 -5.727*
Ln (Y) -0.926 -5.421*
Ln ( π ) -1.730 -4.985*
Ln(ER) -2.964 -5.610*
Ln ( R ) -2.968 -8.681*
Ln (M) -2.207 -7.348*
Test critical values
*:1% level -4.025
**:5% level -3.442
***:10% level -3.146

On the basis of the above unit root tests, we apply the producer of Johansen (1988, 1991) and
Johansen and Juselius (JJ) (1990, 1992, and 1994) is to determine whether any combinations of the
variables are co-integrated. Before undertaking the co-integration tests, we first specify the relevant
order of lags ( ρ ) of the VAR model.

Table 2: Johansen Maximum Likelihood Test for Co-integration

Null Hypothesis Alternative hypothesis Trace Statistic 0.05 Critical Value

r =0 r≥1 181.93 103.84
r≤ 1 r≥2 111.69 76.97
r≤2 r≥3 69.56 54.07
r≤ 3 r≥4 39.04 35.19
r≤4 r≥5 19.84 20.26
r≤5 r≥6 8.01 9.16

The results obtained from the JJ tests are presented in the Table-2: starting with the null
hypothesis of no co integration (r =0) among the variables the trace statistic is (181.93) which above
the critical value of (103.84) .Hence it rejects the null hypothesis r =0 at 5% level of significance in the
favor of specific alternative that there is co-integrating vector r ≥ 1 .As is evident in Table-2 the null
hypothesis of r ≤ 1, r ≤ 2 and r ≤ 3 can also be rejected at a 5% level of significance and the r ≤ 4
and r ≤ 5 cannot be rejected at 5% level of significance. Thus, we conclude that there are four co-
integrating relationship among the six variables of money demand, interest rate, economy activity,
inflation, stock prices and Exchange rate.

Long-run elasticities
Having found the long-run relationship exists between the money demand function and its
determinants; in this section our goal is to estimate long-run elasticities. We achieve this through by
using, Phillips and Hansen (1990) fully modified ordinary least squares (FMOLS) and JJ
normalized co-integration regression. We report the result in table-3, results shows that the economic
activity and inflation is positively and opportunity cost variable is negatively (statistically significant)
associated to demand for money.
Middle Eastern Finance and Economics - Issue 3 (2009) 94
Table 3: Long Run Elasticities

Dependent Variable: Ln (M)

Normalized co-integrating coefficients FMOLS
Variable Coefficient T- Statistic Coefficient T- Statistic
Constant 4.48 6.60 4.39 6.85
Ln (SP) 0.24 6.25 0.18 4.83
Ln ( π ) 0.28 3.62 0.26 3.86
Ln (Y) 1.23 13.66 1.18 14.77
Ln(ER) - 0.09 -0.99 0.07 0.77
Ln (R) - 0.21 -5.5 -0.20 -5.76

Exchange rate is statistically insignificant. The important result of this study is that stock prices
elasticity positive and significantly indicates that stock prices have a positive wealth effect on the
money demand in Pakistan.

Error Correction Estimation

Co-integral relationship establish between the money demand, economic activity, interest rate,
inflation, stock returns and exchange rate, it is possible to specify and estimate an error correction
model.

Table 4: Error correction estimation result

Variable Coefficient t-Statistic Prob.

Δ (M(-1)) -0.22 -2.67 0.01
Δ (M(-2)) 0.15 1.81 0.07
Δ (Y) 0.07 2.98 0.01
Δ (ER) -0.04 -0.78 0.43
Δ (π ) -0.29 -2.39 0.01
Δ (R) 0.007 0.68 0.49
Δ (SP) 0.02 0.88 0.37
ECM(-1) -0.092 -3.64 0.01
C 0.04 7.19 0.00
R-squared 0.423060
Adjusted R-squared 0.388094
Durbin-Watson stat 1.849394

Table-4 shows the result of error correction model, the error correction term has the negative
sign and statistically significant (at 1% level). The coefficient value of error correction term is 0.092,
which suggest that 9.2 per cent of discrepancy between; long run is eliminated within quarter of year.
The coefficient of inflation is negative and statistically significant. This means that the in the short run
increase in prices will leads to decrease the demand for money in the developing economy like
Pakistan. Economy activity positively and significantly effects on the demand for money in the short
run. On the other hand the exchange rate, stock prices and rate of interest insignificantly effect on the
demand for money in the short run.

4. Conclusion
The goal of this paper is to estimate the association between exchange rate, stock Prices and demand
for money function in Pakistan for the period 1971:1 – 2006:4.We estimate the money demand
function by using the robust co-integration tools. The JJ Co-integration result suggest that there are
four co-integrating vectors in money demand, interest rate , economic activity, inflation, stock prices
and exchange rate. Important findings of this paper are that stock prices positively and statistically
95 Middle Eastern Finance and Economics - Issue 3 (2009)

significant and exchange rate insignificantly associated to money demand in the long run. But in the
short run the inflation negatively and significantly effect on the money demand. The stock prices
positively wealth on money demand in the long run. Hence an increase in stock prices is expected to
dictate an easier monetary policy to prevent a given nominal income or inflation target being
undershot.

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