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The relationship between share prices and the macroeconomic variables has been comprehensively treated both by economists and finance specialists. In the contemporary scenario, which can be described by increasing integration of the financial markets and implementation of various stock market reform measures in India, the activities in the stock markets and their relationships with the macro economy have assumed substantial importance. The national stock markets are different since they operate in the economic and social environments of different countries. Accordingly, a country’s financial market is efficient when prices reflect the fundamentals and risks of that country, rather than the fundamentals, risks of other countries. The informational efficiency of national stock markets has been extensively examined through the study of causal relations between stock price indices and macroeconomic aggregates. It can be argued that if real economic activity affects stock prices, then an efficient stock market instantaneously reacts and incorporates all available information about economic variables. The rational behavior of market participants ensures that past and current information is fully reflected in current stock prices. As such, investors are not able to develop trading rules and, thus may not consistently earn higher than normal
returns. Therefore, it can be concluded that, in an informationally efficient market, past (current) levels of economic activity are not useful in predicting current (future) stock prices. Besides, informational efficiency in the stock market exists if a unidirectional causal relationship runs from a macroeconomic variable to stock prices. Moreover, the causality running from lagged values of stock prices to macroeconomic aggregate does not violate informational efficiency. This would imply that stock prices lead the economic variable and that the stock market makes rational forecasts of the real sector. From the beginning of the 1990s in India, the capital market has witnessed a major transformation and structural change as a result of the ongoing financial sector reforms. Gupta (2002) has rightly pointed out that improving market efficiency, enhancing transparency, checking unfair trade practices and bringing the Indian capital market to a certain international standard are some of the major objectives of these reforms. These reform measures have resulted in significant improvements in the size and depth of stock markets in India. At present, the movement of stock market in India is viewed and examined vigilantly by a large number of global investors and market participants. Thus, understanding the macro dynamics of Indian stock market may be useful for policy makers, traders and investors. This finding may reveal whether the changes in stock prices are due to changes in macroeconomic variables of the economy or vice versa.
Against this background, the present paper is an attempt to examine the causal nexus between the share price and macroeconomic variables in India. The study employed the Johansen and Juselius cointegration technique and vector error correction model in a multivariate framework to investigate the objective which involves certain crucial
macroeconomic variables, namely, money supply, interest rate, exchange rate, index of
industrial production and consumer price index. The rest of the paper is organized as follows: A review of the related literature is presented, followed by the presentation of the methodology used in the study. Subsequently, the empirical results are discussed, and finally, the conclusion is offered.
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