Macroeconomics

This study investigates the short-term relationship between the UK stock market index (FTSE 100) and six macroeconomic variables during the period 2000-2013 using a multivariate vector autoregression and Granger causality tests. Variance decomposition and impulse response functions are used to measure the shocks of a variable from the other variables and the Granger causality test is used to investigate the lead-lag relationships among these variables.

Introduction

The purpose of this dissertation is to examine the short run dynamic relationship between the UK stock market and several macroeconomic variables which are industrial production, which is a proxy for economic activity, inflation, money supply, short-run and long-run interest rates and personal consumption expenditure for the period 2000-2013 using a vector autoregression (VAR) and Granger causality. This allows us to investigate dynamic interactions and causal relationships among these variables. The choice of variables is based on the fact that these are generally put forward as the most important variables used in specifications. However, it is perhaps not the case that consumption is always included in these specifications. The reason for the inclusion of consumption is we would like to examine the impact of the so-called “wealth effect.”

The period 2000-2013 was chosen due to its recentness, the fact that it covers the global financial crisis and also there seems to be no empirical work carried out during this time period. After significant research we could only come across three papers that examine the relationship between the UK stock market and macroeconomic variables . The methods used in these papers are: Arbitrage Pricing Theory...

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... carried out VAR analysis on US stock returns and macroeconomic variables. Ratanapokoran and Sharma found that, using variance decomposition, that stock prices are somewhat exogenous relative to other variables. This result is arrived at as he finds that 87% of stock price variance is explained by its own shock. He goes on to argue that this finding is a result of stock prices being less dependent on macroeconomic variables and more reliant on themselves. He also finds that macroeconomic variables do not have an effect on stock prices. The major finding of Dhakal and Khandil’s paper is that there is a “direct causal impact” of changes in the money supply on stock prices. They attribute this to changes in the money supply having an influence on the interest rate and inflation whereby the change in interest rates and inflation impacts indirectly on share prices.