Causal Relationship between Aggregate Economic Variables and Stock Market (Evidence from Pakistan)

Abstract

Over the past few decades economists are trying to explore the effect of aggregate economic variables on capital market. Literature disclosed relationship between capital market and state variables; however the direction of causality still remains unsolved. This paper investigates the causal relationship between aggregate economic variables (gross domestic product, industrial production index, exchange rate, inflation and unemployment rate) and stock market, using quarterly data from 1992 to 2010. Granger causality test is applied to check the causality between the variables. Results indicate that there is bidirectional causality between stock market and three aggregate variables including GDP, IPI and Exchange rate. While unidirectional causality found between capital market and two macro variables i.e. Inflation and Unemployment, the direction of causality flows from aggregate variables to capital market. This study will facilitate the investors in taking effective investment decision by analyzing the macroeconomic factors, and estimating the direction of equity prices to allocate their resources effectively.