Co-integration and causality analysis of dynamic linkage between economic forces and equity market: An empirical study of stock returns (KSE) and macroeconomic variables (money supply, inflation, interest rate, exchange rate, industrial production and reserves)

Abstract

This study explores the short and long term dynamic relationship between macroeconomic variables and stock returns (KSE) for the period from January 1999 to December 2008. Macroeconomic variables include money supply, consumer price index, treasury bills rates, exchange rate, industrial production and reserves. The time series data have been used to examine by employing Johansen and Juselius multivariate cointegration, bivariate cointegration and Granger causality which indicates long term relationship among money supply, consumer price index and industrial production. Granger Causality test provides evidence about lead lag unidirectional relationship between macroeconomic variables and stock returns (KSE). Vector error correction model explores the short term dynamic negative significant relationship among interest rate, exchange rate and also inflation on Karachi Stock Exchange. Money supply has a positive impact, creates the liquidity and accepts the null hypothesis of positive impact on equity market. Variance decomposition test determined that macroeconomic variables are an important source of volatility for the Karachi Stock Exchange. The contribution of this research is used to identify macroeconomic variables that are considerable factors and determinants of Karachi Stock Exchange movements. It also indicates that policy makers should be more careful and watchful about the sensitivity in designing the monetary policy. Key words: Karachi Stock Exchange (KSE), dynamic, macroeconomic variables, causality, vector error correction model (VECM), cash inflows, present value, co-integration.