Abstract
The study aims at examining how fiscal deficits affect the performance of the stock market in India by using annual data from 1988–2012. The study makes use of Ng-Perron unit root tests to check the non-stationarity property of the series; the Auto Regressive Distributed Lag (ARDL) bounds test and a Vector Error Correction Model (VECM) for testing both short and long run dynamic relationships. The variance decomposition (VDC) is used to predict the exogenous shocks of the variables. The findings of the bounds test reveal that the estimated equation and the series are co-integrated. The ARDL results suggest a long run negative relationship exists between budget deficit and stock prices and do not show any significant relationship in the short run. The VECM result shows that fiscal deficits influence the stock price only in the short run. The results of the Variance Decomposition show that stock price movement in the long run is mostly explained by shocks of fiscal deficits. The study implies that the government must adopt appropriate macroeconomic policies to reduce budget deficit, which will result in stock market growth and in turn will lead to the financial development of the country.
Highlights
The stock market plays an important role in economic prosperity, fostering capital formation and sustaining the economic growth of an economy [1,2,3,4]
Before we proceed to Auto Regressive Distributed Lag (ARDL) testing, we test for unit root of the variables to determine their order of integration
The analysis of the unit root test results indicates that the variables are integrated order one (I(1)) and none of the variables are I(2) series 3
Summary
The stock market plays an important role in economic prosperity, fostering capital formation and sustaining the economic growth of an economy [1,2,3,4]. The current and the future economic growth of the economy depend on country’s stock market performance up to some extent and the stock market performance depends on the country’s fiscal budget. This is partly due to the notion that a large budget deficit could affect the current and future economic growth of the nation through its effects on the stock markets. Large budget deficits could lead to a stock market crash [5]. Budget deficits affect stock prices through anticipated future taxes, if tax rates are below their revenue-maximizing levels [6]. Friedman [7] claims that budget deficits have little effect on stock prices
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