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International Journal of Economics, Commerce and Management

United Kingdom

Vol. V, Issue 1, January 2017

http://ijecm.co.uk/

ISSN 2348 0386

REAL STOCK PRICES AND THE LONG-RUN DEMAND


FOR MONEY IN SAUDI ARABIA
Saad M. Alnefaee
Department of Finance, College of Administrative & Financial Sciences
Saudi Electronic University, Jeddah, Kingdom of Saudi Arabia
s.alnafaiei@seu.edu.sa

Abstract
This paper investigates the relationship between real stock prices and the long-run demand for
money in Saudi Arabia for the period of 19852014. Using the Johansen test for cointegration
and error correction presentation, the paper examines the short-run dynamics of the demand for
money. Moreover, a Granger causality test is conducted. The findings indicate that real stock
prices have a significant negative substitution effect on the long-run demand for the real M2
balance. Vector error correction results provide evidence of causality between real stock prices
and demand for money and inflation in one lag, whereas money demand affects income and
inflation in the same period.
Keywords: Money demand, Real stock prices, Real M2 balance, Granger causality, VECM

INTRODUCTION
The Saudi economy is characterized by heavy dependence on oil production and exports.
Changes in oil production and prices influence government expenditures and economic
activities, as well as the demand for money. In response to the sharp decline in oil prices, the
Saudi government has embarked on a series of economic reforms over the past year and has
recently set out plans for an ambitious transformation of the Saudi economy in Vision 2030 and
the National Transformation Program. The program aims to diversify the economy and increase
the private sectors role by emphasizing privatization and public-private partnerships, improving
the business climate, developing local capital markets, promoting foreign direct investment, and
supporting small and medium-sized firms. According to the International Monetary Fund (IMF)

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2016 Article IV report, the program will help diversify the economy, create jobs for nationals in
the private sector, and implement a gradual and sustained fiscal consolidation.
Like most emerging economies, the financial system in Saudi Arabia is dominated by
commercial banks. The current structure consists of 12 local commercial and a few foreign
banks that play a limited role. The scope and size of the activities of domestic banks have
increased significantly in recent years due to the adoption of Sharia-compliant financial
products. On the stock market front, Saudi Arabia has gone through phases of financial
liberalization, starting from deepening the stock market to allowing foreigners to buy local
shares. In September 2016, the Saudi Stock Exchange (Tadawaul) allowed foreign investors to
own a maximum of 49% of any listed company.The main motive behind this work is that no
previous attempt has been made to study the stock markets role in the long-run demand for
money in Saudi Arabia. Accordingly, this will contribute to the literature by producing empirical
analysis of the behavior of the demand for money. Specifically, the study objectives are (a) to
determine whether a stable long-run relationship exists between real stock prices and the
demand for money in Saudi Arabia and (b) to explore the causality and direction of the effects
on money demand.
LITERATURE REVIEW
Several pieces of literature have examined the behavior of stock markets. Friedman (1988)
wrote a major study that attempted to evaluate the link between stock market prices and the
demand for money. He argued that increases in stock prices have a positive wealth effect and a
negative substitution effect on the demand for money. The positive wealth effect may be due to
three factors: the implied increase in nominal wealth, an increase in the expected return from
risky assets relative to safe assets, which induces economic agents to hold a larger amount of
safer assets such as money, and an induced rise in the volume of financial transactions that will
require higher money balances to facilitate them. The substitution effect of real stock prices on
money demands implies that as stock prices rise, equities become more attractive when
compared to other components in a portfolio; thus, a shift from money to stocks may occur.
Consequently, the sign on the stock price variable in the demand for money model can be
positive or negative. Most of the studies on the relationship between stock prices and money
demand have been confined to developed countries, while little research has been conducted
on developing countries. Choudhry (1996) studied real stock prices and the long-run money
demand function using the vector error correction model (VECM) in Canada and the United
States for 19551989. He found that stock prices play a significant role in determination of the
money demand function in both Canada and the United States, though neither the size nor the

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direction of the effect is identical in every relationship. Thornton (1998) examined the existence
of a long-run relationship between stock prices and demand for money in Germany. Study
showed that real stock prices have a significant and positive wealth effect on the long-run
demand for a narrow money balance in Germany. In developing economies, Baharumshah
(2004) studied the stock prices and the long-run demand for money in Malaysia. He found that
stock prices have a significant negative (substitution) effect in the money demand equation..
Baharumshah, Mohd, and Yol (2009) found that stock prices have a significant positive effect on
the demand function in China in the long run and a substitution effect in the short run.
Muhammad et al. (2009) investigated the relationships among stock prices, exchange rate, and
demand for money in Pakistan. The study found that stock prices have a positive wealth effect
on money demand in the long run. Kumari and Mahakud (2012) examined the relationships
among stock prices, exchange rate, and the demand for money in India. Their study showed
that stock prices have a negative wealth effect on long and short money demand. Most of the
research on money demand in Saudi Arabia, such as Aalkswani and Altowaijri (1998), Albazai
(1998), Abulkheir (2013), and Hamdi et al. (2014), has focused on testing the existence of a
stationary long-run equilibrium among real money balance, real income, interest rate, inflation,
and exchange rate. This study complements the previous studies by taking into account the
possible role of stock prices in determining the money demand function for Saudi Arabia. The
reason for including real stock prices in the demand for money for Saudi Arabia is that we
believe stock prices are a part of the assets portfolio held by investors.

Moreover, the

improvement in stock market prices in recent years has attracted Saudi citizens and increased
the number of individual share portfolios in local banks. E.g. the number of customers registered
in the Saudi Stock Exchange (Tadawul) increased from 2.5 million in 2005 to 4.5 million in 2015.

METHODOLOGY
The Model
Following the work of Friedman (1988) and Choudhry (1996), as well as Baharumshah et al.
(2009), the money demand function that includes stock market prices is as follows:
(M/P) = f(y, r, p, sp)

(1)

Where, (M/P) is demand for real balance, M is nominal money (m2), P is price level, y is real
nonoil (GDP/p), r represents interest rate, and sp is real stock prices. Taking a log of the real
money balance, income, and stock prices, we obtain the following:
ln(m - p) = 0 + 1ln(y) + 2 r + 3 P + 4ln(sp) + ut

(2)

Where, ln denotes the natural logarithm and ut is the residual term. The parameters of the
model (s) measure the sensitivity of the variables to the money process. Based on Laidler

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(1993), we expect the estimate of 1 to have a positive sign and 2 and 3 a negative sign,
while 4 could be negative or positive.
Data
Due to limited data on stock prices before 1985, we used annual data for 1985 through 2014.
We obtained data for the monetary aggregate, income, inflation, stock prices, and interest rate
from various issues of the annual report of the Saudi Arabian Monetary Agency (SAMA).
ANALYSIS AND DISCUSSION OF RESULTS
We used the VECM integration technique (Johansen, 1988) and Johansen and Joselius (1990)
to test the long-run cointegration relationship between the demand for money and its
determinants. Before conducting the cointegration test and using the VECM, we checked for
the stationarity of the variables of the money demand relation. According to Nelson and Plosser
(1995), many time series can be characterized as nonstationary. A popular unit root test is the
augmented DickeyFuller (ADF) test (Dickey & Fuller, 1981). To avoid the potential problem of
estimating spurious relationships, it is necessary to test the time series properties of the variable
under investigation for unit roots. If a variable is stationary (i.e., it does not have unit roots), it is
said to be I (0) (integrated on an order of 0). If a variable is not stationary in its level form but
stationary in its first-difference form, it is said to be integrated on an order of 1, or I(1).

Unit Root Tests


According to the results shown in Table 1, the null hypothesis of the unit root is rejected at the
1% and 5% levels. This suggests that each variable is nonstationary in the level and stationary
in the first difference. No further tests were performed. We therefore maintained the null
hypothesis that each variable is integrated on an order of 1. The lag length for each series is
determined based on the Schwarz Bayesian criterion (SBC) and Akaike information criterion
(AIC; Enders, 1995). Based on that, we moved to the next step of conducting cointegration test.

Table 1. Tests of Time Series Stationary at First Difference


Variable

DickeyFuller
(level)

DickeyFuller (first
difference)

LM2
2.45 **
3.13**
P
0.120**
6.19**
LGDP
1.57*
4.29*
R
1.98**
4.8**
LSP
1.27**
6.23**
Note. *, **: statistically significant at the 5% and 1% levels, respectively.

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Cointegration Technique
Cointegration is a technique used to test whether or not a long-run relationship exists between
nonstationary economic variables. Two methods are used to estimate the cointegration
variableEngle and Grangers cointegration test procedure and the Johansen maximum
likelihood procedure. The first test approach is limited to bivariate analysis, while the other is
developed to test multivariate series. The latter is the most widely accepted procedure for
cointegration analysis in the current literature. The Johansen maximum likelihood procedure is
summarized in the following error correction form:
Xt = 1 Xt-1 +.+ kt-1 Xt-k+1 + Xt-k + + t (3)
Where, Xt represent the vector of observations of all variables in the system at time t, the are
estimable parameters in the short run, is a constant vector, t is a vector of white noise, and
the matrix contains the cointegrating relationships. All variables must be nonstationary in
levels.
We hypothesized that = , where the cointegrating vectors are in the matrix and
the matrix describes the speed of adjustment for each variable change to return to its long-run
equilibrium (Philips & Cutler, 1998). In this test, we looked for the number of cointegration
vectors to appear in the series. The presence of at least one cointegrating vector is sufficient to
establish the existence of cointegration among the variables. Like Abdulkheir (2013), we used
the twin statistics of trace and maximum eigenvalue to determine the number of cointegration
vectors. The Johansen cointegration statistics are reported in Table 2.
The test for cointegration between M2 and its explanatory variables showed that
cointegration in fact exists between the variables of the model with one cointegrationvector at
the 5% significance level. Therefore, it was possible to estimate the long-run equilibrium
relationship between M2 and its explanatory variables and conduct the VECM to estimate the
short-run relationship.

Table 2. Results of Johansen Estimation Procedure


Trace Statistic
5% Critical Value
Max-Eigenvalue Statistic
5% Critical Value
81.69236*
69.81889
34.12915*
33.87687
47.56321
47.85613
22.69076
27.58434
24.87245
29.79707
14.50781
21.13162
10.36463
15.49471
9.020583
14.26460
1.344094
3.841466
1.344094
3.841466
Note. * denotes rejection of the hypothesis at 0.05 level; trace and max eigenvalue tests indicate 1
cointegrating equation.

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Granger Causality
As Engel and Granger (1987) pointed out, if two variables are cointegrated, then Granger
causality must exist in at least one direction. To conduct the Granger causality tests, different
lags were used to determine the direction of causality to and from money demand. The results
of the causality tests are shown in Table 3. The results demonstrate that real stock prices affect
the M2 and inflation in one lag (in one year). Also, money demand affects income and inflation
in the same period.

Table 3. One Lag Causality Test Result


Causality Direction
LM2 does not Granger cause inflation
LM2 does not Granger cause LGP
LSP does not Granger cause LM2
LSP does not Granger cause inflation
R does not Granger cause LSP

F-test
4.84244
3.51841
9.05703
7.74109
4.45116

Probability
0.0372
0.0742
0.0059
0.0101
0.0451

VECM Result
We summarize the result from the VECM as follows:
D(m2) = 0.34*(lM2(-1)+2.25 lgdp-0.02 r- 0.01 cpi -0.33 sp+12.6 -0.37 Dlm2(-1)- 0.29 Dlm2(-2)
0.27lgdp(-1)- lgdp(-2)- 0.01r(-1) +0.11r(-2) + 0.001cpi(-1)- 0.11cpi(-2)-0.02 lsp(-1)- 001 lsp(2)+0.18
The long-run parameter estimate for income was positive with a large coefficient of 2.25. This
estimate means that a 1% increase in real income on average increases the demand for money
by 2.25%.

We also found that the parameter estimate on stock prices was negative and

significant with a coefficient of -0.33. This estimate indicates that a 1% increase in the stock
prices on average decreases the demand for money by 0.33%. The signs of the estimated
long-run parameters were consistent with prior expectations; however, they differed in
magnitude. The sign on income was positive, and interest rate and inflation carried negative
signs, while the sign on stock prices was negative (-0.33) and statistically significant, indicating
that stock prices have a negative (substitution) effect on the money demand in Saudi Arabia.
The sign on the stock prices was also consistent with Friedmans finding on the United States
and Bahararumshahs results on the Malaysian data. The short-run analysis showed that the
coefficient of the ECt-1(0.34) was significant and revealed that approximately 34% of last years
discrepancy between money demand and its long-run equilibrium value was corrected by as
much as 34%. The short-run income elasticity was less than that of the long run (0.27). The
real stock prices, interest rate, and inflation variables carried negative coefficients, as expected,

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but were insignificant. We noticed that the long-run impact of stock prices was much greater
than in the short run. A possible explanation is that investors prefer to keep shares as a store of
value in the long run.
CONCLUSIONS AND RECOMMENDATIONS
This paper is an attempt to investigate the role of stock prices and the long-run demand for
money in Saudi Arabia. The empirical investigation is conducted by using Johansons procedure
of cointegration to test for the existence of a long-run relationship among money balance,
income, interest rate, inflation, and stock price for 19852014, and error correction modeling of
the data was used to explain the short-run dynamics of the demand for money. Furthermore, a
Granger causality test was carried out. The results show that stock prices have a significant and
negative substitution effect on the long-run demand for the real M2 balance. The unidirectional
Granger causality tests show that stock prices affect both the demand for money and inflation
with a one-period lag. In general, the results indicate the existence of a stable money demand
and that M2 is a suitable monetary target. At the same time, the inclusion of real stock prices in
the money demand function is essential for the stability of M2. The empirical evidence of a
negative substitution effect suggests that an increase in stock prices calls for a tight monetary
policy to prevent high inflation and nominal income. Finally, we hope that future research can
examine these relationships using quarterly data to add to this line of research.

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