This study adopts Cointegration approach and Granger causality analysis to empirically test the role of real stock prices in the long-run money demand in the Indonesian economy for the period from the second quarter of 1998 to the fourth quarter of 2007. The real narrow money (M1) is found to be cointegrated with the Real Gross Domestic Product (RGDP), 3-month Bank Indonesia Certificate (BIC-3) rates and Real Stock Prices (RSP). This finding implies that there exists a long-run co-movement among these variables in the Indonesian economy. The results also suggest that RSP has a positive and significant role in determining the long-run demand for M1. In addition, RSP and M1 are found to have a bidirectional causality. This further implies that in designing economic policies pertaining to the stock market, the Indonesian government through the Central Bank of Indonesia may also use money balance as opposed to the current practice of adopting interest rates, as their monetary policy. On the contrary, controling the stability of money balance in the long run can be achieved indirectly by regulating the stock market.

There are not many regular studies on the direct relationship between stock prices and money demand functions, both in the developed and developing economies. This does not mean that there was no particular scheme of thought that had been used to explain such a relationship. In fact, Friedman (1988) indirectly included stock prices in total non-human wealth and empirically showed that the prices play a significant role in determining money demand function. On the other hand, money demand function, apart from being induced by stock prices, is also conjectured to be influenced by other intimately but indirectly related factors. In particular, it is assumed that there exists an underlying stationary long-run equilibrium and real money balances, real income or real wealth and the opportunity of holding money balances. The last factor is generally represented by interest rates.

Friedman (1988) also demonstrated that there are at least two effects of stock prices (wealth) movement on the demand for money, viz., positive wealth effect and negative substitution effect. The first effect, which may positively affect wealth and in turn demand for money, is as follows: (1) Any increase (decrease) in stock prices is an indication of the increase (decrease) in nominal wealth; (2) Any increase (decrease) in stock prices is a reflection of the rise (decline) in the expected returns from risky assets relative to safe assets. This will then induce the economic agents to hold a larger amount of safer assets like money; and, (3) Any increase (decrease) in stock prices is a signal of inducing a rise (fall) in the volume of financial transactions, which in turn will lead to higher money demand balances.

Applied Finance Journal, Real Gross Domestic Product, RGDP, Real Stock Prices, RSP, Economic Policies, Real Stock Prices, RSP, International Financial Statistics, IFS, International Monetary Fund, IMF, The Consumer Prices Index, CPI, Financial Markets, Monetary Dynamics, Statistical Analysis, Error Correction Model, ECO.