In the past three decades the focus of researchers and policy makers shifted from money to interest rate as monetary policy instrument owing to low predictive and explanatory power of the former for the target variables – real economic activity and the inflation rate. In this study, we hypothesize that the apparent weak relationship between money and the target variables, found in empirical literature, is predominantly due to the absence of asset prices in the empirical models (see for instance, Bernanke and Blinder, 1992). We test our hypothesis using data of the Pakistan economy over the period 1981 Q1 to 2018 Q2. We compare the forecasting power of interest rate with that of money stock for goods prices and real economic activity in the presence of asset prices. This has been done using Granger causality test and by decomposing variances of the GDP deflator rate and output. In both cases, the predictive power of money, for the prices and output, significantly increases when asset prices are considered in the model. Moreover, as a second objective, we also find out the moderating role that asset prices play in strengthening or weakening the relationship between money and the target variables. This has been done using two different methods; the two steps regression based method and by incorporating an interaction term of asset prices and money in the regressions of the target variables. In both cases, we find evidence of asset prices affecting the relationship between money and the target variables. More specifically, the asset prices proved to weaken the relationship between money and price level and strengthen the relationship between money and the economic activity. The study is important in two respects; the role of asset prices in prediction of money for the prices and output has been contributed to the empirical literature of Pakistan and the results have strong policy relevance.

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