Stock Market Fluctuations and Money Demand in Italy, 1913–2003

Abstract

This paper examines the impact of stock market fluctuations on money demand in Italy from a long‐run perspective. The money demand function estimated by Muscatelli and Spinelli (2000) for a long time span is utilized as a benchmark, adding to the specification information on share prices from the Milan Stock Exchange Reform of 1913 to recent years. For a shorter time period (1938–2003), annual observations on stock market capitalization and turnover velocity are also considered. The empirical findings suggest that stock market fluctuations help to explain temporary movements in liquidity preference, rather than its secular patterns. Overall, a positive association emerges between an index of stock market prices that includes dividends and real money balances; however, the estimated long‐run relationship is unstable. In a dynamic, short‐term specification of money demand, the estimated coefficient of deflated stock prices is positive, and therefore compatible with a wealth effect, in the years 1913–1980, while in the last two decades a substitution effect has prevailed and the correlation between money and share prices has been negative. This is likely to reflect a change in financial structure and the increasing role of opportunity costs defined over a wider range of assets. These results are confirmed by data on stock market capitalization. Moreover, in the recent period, stock market turnover and money growth are positively correlated.