On the Causal Relationship between Stock Prices and Exchange Rates: Evidence from Romania

Abstract

The paper investigates the dynamic links between stock prices and exchange rates in Romania, considering the changes in the exchange rate regime occurred after 1997. The research employs advanced econometric methods - cointegration and innovation accounting techniques, in order to capture the relationship between stock prices, exchange rates and other macroeconomic variables, applied to monthly data over the January 1998 - September 2007 period. We identify a long-term equilibrium relationship between stock prices, official reserves and nominal effective exchange rates, while the real exchange rate and the money supply are found not to be statistically significant in any of the models. The signs of variables in the cointegrating vectors are consistent with economic reasoning: we find there is a positive relationship between money supply and stock prices, on one hand, and between the nominal effective exchange rate and stock prices, on the other hand. Also, there is a negative relationship between official reserves and stock prices, and between the real effective exchange rate and stock prices. Conversely, while over the short run stock prices react mainly to their own one standard deviation shocks, over the long run we observe that shocks in money supply and reserves generate responses from stock prices.