Aggregate Economic Variables and Stock Markets in India

Abstract

This study investigates the nature of the causal relationships between stock prices and the key macro economic variables representing real and financial sector of the Indian economy for the period March, 1995 to March, 2007 using quarterly data. These variables are the index of industrial production, exports, foreign direct investment, money supply, exchange rate, interest rate, NSE Nifty and BSE Sensex in India. Johansen`s approach of cointegration and Toda and Yamamoto Granger causality test have been applied to explore the long-run relationships while BVAR modeling for variance decomposition and impulse response functions has been applied to examine short run relationships. The results of the study reveal differential causal links between aggregate macro economic variables and stock indices in the long run. However, the revealed causal pattern is similar in both markets in the short run. The study indicates that stock prices in India lead economic activity except movement in interest rate. Interest rate seems to lead the stock prices. The study indicates that Indian stock market seems to be driven not only by actual performance but also by expected potential performances. The study reveals that the movement of stock prices is not only the outcome of behaviour of key macro economic variables but it is also one of the causes of movement in other macro dimension in the economy.

Keywords: Cointegration Test, T-Y Granger Causality Test, Variance Decomposition, Impulse Response Function

JEL Classification: G1, C22