Real Stock Prices and the Demand for Money in Saudi Arabia

Abstract

Empirical research on money demand has long been concerned with the degree of substitutability between money and other capital assets and the impact on money holding of financial markets development and financial innovation. Therefore, movements in stock prices may have two effects on money demand wealth effect and substitution effect. The emergence of regulated stock market in Saudi Arabia and its rapid expansion has attracted considerable attention and involvement of the private sector. With quarterly data, this study attempts to determine whether there exists a stationary long run relationship between money demand and real stock prices in Saudi Arabia. By employing recent developments in econometrics methodology, the results obtained show that rising stock prices exert an impact on money demand (especially M2) driven by wealth effect. However, the substitution effect may occur, which may reduce money demand and raise the possibility to transfer them to interest bearing assets. Thus, it can be concluded that real money demand function requires the inclusion of real stock prices in the relationship.