The relationship between macroeconomic variables and stock market indices 1.1 Introduction and Background
The financial system is considered to be the key to economic growth. A well developed and sound financial system promotes investment by the identification and financing of profitable business opportunities, through the mobilization of savings, the efficient allocation of resources, by helping to diversify risks and by facilitating the exchange of goods and services. (Mishkin, 2001). As such, stock markets have assumed a developmental role in international economics and finance following the impact they have exerted on economic activity. Stock markets are known not only as the foundations of a modern, market based economic system but they also act as channels for the movement of long term financial resources from the savers of capital to the borrowers of capital. Therefore, efficient capital markets have an instrumental role to play in economic growth and prosperity.
Fama, who is often quoted as the father of the efficient market hypothesis has described an efficient market as one in which security prices adjust rapidly to the arrival of new information and therefore, the current prices of securities reflect all information about the security. In simpler terms, this means that no investor should be able to employ readily available information to be able to predict movements in stock prices quickly enough in order to make profit through trading of shares. Thus, the efficient market hypothesis requires stock prices to contain all relevant information. 1.2 Professional Significance and Rationale
This study is important for several reasons. The EMH (Efficient Market Hypothesis), in particular the semi strong from efficiency is considered to be of paramount importance for economists, policy makers and investors alike. The semi strong form of EMH asserts that all publicly available information for example accounting data in a company’s annual report such as earnings announcements and dividend increase announcements should be reflected in stock prices. Information inefficiency in stock market hence implies that market participants are able to develop profitable trading rules and can thereby consistently earn more than average returns, and on the other hand the stock market is not likely to play an effective role in channelling financial resources to the most productive sectors of the economy.
While finding causality from lagged values of stock prices to an economic aggregate does not violate informational efficiency, this finding is equivalent to the existence of causality from current values of stock prices to future economic variable. This would suggest that stock prices lead the economic variable and that the stock market makes rational forecasts of the real sector. If stock prices accurately reflect the underlying fundamentals, then the stock prices should be employed as leading indicators of future economic activity, and not the way around. Policy makers should thus feel free to conduct national macroeconomic policies without the fear of influencing capital formation and the stock trade process. Therefore, the causal relations and dynamic interactions among the macroeconomic variables and stock prices are important in the formulation of a nation’s macroeconomic policy Money supply and interest rate are macroeconomic variables which have an effect on stock prices. As far as they are concerned, the EMH has suggested that in an efficient market competition between profit maximizing investors will make sure that the current stock prices reflect all the information which are currently known regarding the changes in macroeconomic variables. Thus, investors will not be able to take advantage and earn abnormal profits by predicting the future stock market movements. (Chong and Koh, 2003). Therefore, if one were to believe the conclusions drawn by the EMH, investment advisors would not be able to help investors earn above...
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