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Short-Run and Long-Run Causality between Monetary Policy Variables and Stock Prices

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  • Jean-Marie Dufour
  • David Tessier

Abstract

The authors examine simultaneously the causal links connecting monetary policy variables, real activity, and stock returns. Their interest lies in the fact that the dynamics of asset prices can provide key insights--in terms of information--for the conduct of monetary policy, since asset prices constitute a class of potentially leading indicators of either economic activity or inflation. This is of particular interest in the context of an inflation-targeting regime, where the monetary policy stance is set according to inflation forecasts. While most empirical studies on causality have examined this issue using Granger's (1969) original definition, the authors examine the causality relations through the generalization proposed in Dufour and Renault (1998). For the United States, the authors find no support for stock returns as a leading indicator of the macroeconomic variables considered, or for stock returns being influenced by those macroeconomic variables, except for one case: fluctuations in M1 tend to anticipate fluctuations in stock returns. Furthermore, the authors' empirical methodology allows them to infer that monetary aggregates may have significant predictive power for income and prices at longer horizons. It is therefore incorrect to dismiss the importance of monetary aggregates based on the usual Granger causality criteria. The causality pattern inferred by the authors' procedure is consistent with the Phillips curve (for the inflation dynamics) and with the Taylor rule in the case of the interest rate. For Canada, the results are much different. The authors show that there is a potential role for asset prices as a predictor of some important macroeconomic variables, namely interest rates, inflation, and output at policy-relevant horizons. Furthermore, some measures of monetary aggregates tend to dominate the interest rate as robust causal variables for output growth and inflation. However, the authors do not find strong evidence in favour of the Phillips curve and the Taylor rule. Finally, for both Canada and the United States, the authors show that seasonal adjustments can highly distort the inferred causality structure.

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Bibliographic Info

Paper provided by Bank of Canada in its series Working Papers with number 06-39.

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Length: 28 pages
Date of creation: 2006
Date of revision:
Handle: RePEc:bca:bocawp:06-39

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Keywords: Monetary and financial indicators;

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References

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  1. James H. Stock & Mark W.Watson, 2003. "Forecasting Output and Inflation: The Role of Asset Prices," Journal of Economic Literature, American Economic Association, vol. 41(3), pages 788-829, September.
  2. Dufour, J.M. & Renault, E., 1995. "Short-Run and Long-Rub Causality in Time Series: Theory," Cahiers de recherche, Universite de Montreal, Departement de sciences economiques 9538, Universite de Montreal, Departement de sciences economiques.
  3. DUFOUR, Jean-Marie, 2005. "Monte Carlo Tests with Nuisance Parameters: A General Approach to Finite-Sample Inference and Nonstandard Asymptotics," Cahiers de recherche, Centre interuniversitaire de recherche en économie quantitative, CIREQ 03-2005, Centre interuniversitaire de recherche en économie quantitative, CIREQ.
  4. Dufour, Jean-Marie & Pelletier, Denis & Renault, Eric, 2006. "Short run and long run causality in time series: inference," Journal of Econometrics, Elsevier, Elsevier, vol. 132(2), pages 337-362, June.
  5. Stephen G. Cecchetti & Hans Genberg & Sushil Wadhwani, 2002. "Asset Prices in a Flexible Inflation Targeting Framework," NBER Working Papers 8970, National Bureau of Economic Research, Inc.
  6. Christopher A. Sims, 1980. "Comparison of Interwar and Postwar Business Cycles: Monetarism Reconsidered," NBER Working Papers 0430, National Bureau of Economic Research, Inc.
  7. Lee, Bong-Soo, 1992. " Causal Relations among Stock Returns, Interest Rates, Real Activity, and Inflation," Journal of Finance, American Finance Association, American Finance Association, vol. 47(4), pages 1591-603, September.
  8. William R. White, 2006. "Is price stability enough?," BIS Working Papers 205, Bank for International Settlements.
  9. Granger, C W J, 1969. "Investigating Causal Relations by Econometric Models and Cross-Spectral Methods," Econometrica, Econometric Society, Econometric Society, vol. 37(3), pages 424-38, July.
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Cited by:
  1. Yun Daisy Li & Talan B. Iscan & Kuan Xu, 2007. "The Impact of Monetary Policy Shocks on Stock Prices: Evidence from Canada and the United States," Department of Economics at Dalhousie University working papers archive, Dalhousie, Department of Economics stock_money19.pdf, Dalhousie, Department of Economics.
  2. Tsouma, Ekaterini, 2009. "Stock returns and economic activity in mature and emerging markets," The Quarterly Review of Economics and Finance, Elsevier, Elsevier, vol. 49(2), pages 668-685, May.

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