A Study on the Dynamic Relationships between Macroeconomic Variables and Stock Market in Taiwan-An application of a Vector Error Correction Model

Abstract

In recent years, the effects of fundamental macroeconomic news on stock price movements have received a considerable attention. The role that macro-economic news plays in explaining the movements in stock prices is very important both for practitioners and academic researchers. Practitioners are perhaps interested in using the information about macroeconomic fundamentals in pricing assets or alternatively making decisions about real investments. On the other hand, academic economists may be interested because this will help them to identify some sources of systemic risks, and to consider whether these risks are priced (as it should be) on the stock market. Financial theory suggests that stock returns are predictable from macroeconomic variables. This study is interested in empirically testing the existence of a long-run relationship between the Taiwan Stock Market Index and its fundamentals, namely the interest rates, exchange rate, unemployment rate, industrial production price Index and consumer price index (CPI). This paper tests the existence of cointegration by Johansen' s procedure and applies Granger causality tests analyzing the causal relationship, which exists between these variables. We also use the approach of a Vector Error Correction Model (VECM) to examine the interaction between Macroeconomic Variables and Taiwan Stock market. The beginning of this empirical data is after the liberalization of the exchange rate in Taiwan in January 1991 and ends in May 2010.