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Abstract
Macroeconomic variables i.e., Economic output, Unemployment and Employment, Inflation play
a vital role in the economic performance of any country. For the past three decades, evidence of
key macroeconomic variables helping predict the time series of stock returns has accumulated in
direct contradiction to the conclusions drawn by the Efficient Market Theory. The majority of
research concentrates on the financial markets of the developed countries, which are efficient
enough and do not suffer from the inefficiency problems in less developed countries, which are
efficient enough and do not suffer from the inefficiency problems in less developed countries.
Considering this matter, the subject of financial markets in developing countries still needs
lengthy analysis and more research attention. This research studies the pattern of CPI, WPI,
GDP, GNI and Rate of interest in India and Sri Lanka for the year 2002-2009 while also
analyzing the impact of macro-economic variable on GDP growth in India vis-à-vis Sri Lanka.
The econometrics tools i.e., Unit root test, Granger causality test, Cointegration test, Vector auto
regression and Variance decomposition, and Variance Decomposition Analysis have been used
for the analysis purpose.
Despite the importance of previous studies, until now the majority of research concentrates on
the financial markets of the developed countries, which are efficient enough and do not suffer
from the inefficiency problems in less developed countries. Considering this matter, the subject
of financial markets in developing countries still needs lengthy analysis and more research
attention.
3. Review of Literature:
For number of years, there has been an extensive debate in the literature assessing the influence
of macroeconomics variables on the stock return. The economic theory, in explaining this
interrelationship, suggests that stock prices should reflect expectations about futures corporate
performance. Corporate profits on the other hand generally may reflect the level of country’s
economic activities. Thus, if stock prices accurately reflect the underlying fundamentals, then the
stock prices should be employed as leading indicators of future economic activity. However, if
economic activities reflect the movement of stock prices, the results then should be the opposite,
i.e economic activities should lead stock price. Therefore, the causal relations and dynamics
interactions among economics factors and stock prices are important in the formulation of
nation’s macroeconomic policy. According to Oberuc (2004), the economic factors which,
usually associated with stock prices movement and being considered greatly by researchers are
dividend yield, industrial production, interest rate, term spread, default spread, inflation,
exchange rates, money supply, GNP or GDP and previous stock returns, among others.
Emerging stock markets have been identified as being at least partially segmented from global
capital markets. In direct contradiction to the conclusions drawn by the EMH, evidence that key
macroeconomic variables help predict the time series of stock returns has accumulated for nearly
30 years.
Numerous studies have investigates the relationship between stock returns, interest rates,
inflation and real activity (see, inter alia, Fama (1981, 1990), James et al. (1985), Fama and
Schwert (1977), Geske and Roll (1983), Mandelker and Tandon (1985), Hendry’s (1986), Chen,
Roll and Ross(1986), Darrat and Mukherjee (1987), Fama and French (1989) , Asprem
(1989),Martinez & Rubio, 1989, Schwert, 1989,Schwert (1990), Ferson and Harvey (1991), Lee
(1992), Mukherjee and Naka (1995), Chatrath et al. (1997), Naka A., Mukherjee T. and Tufte D.
(1998), Ibrahim (1999) , Gjerde & Saettem, 1999, Wongbangpo and Sharma (2002), , and
Vuyyuri (2005).
[
Now we divide the whole work of the researchers on macroeconomic variables in different parts
on the basis of stock markets, tests and conclusions.
Fama (1981) focuses upon the correlation between stock returns and expected and unexpected
inflation in the U.S., showing that the observed negative relation is a ‘proxy effect’ for more
fundamental relationships between stock returns and real activity. James et al. (1985) finds
strong links between stock returns, real activity and money. Investigating the stock return-
inflation relation for the U.S., U.K., Canada and German. Fama and Schwert (1977) estimate the
extent to which various assets were hedges against the expected and unexpected components of
the inflation rate during the 1953–1971 period. They finds that U.S. government bonds and bills
were a complete hedge against expected inflation, and private residential real estate was a
complete hedge against both expected and unexpected inflation. Geske and Roll (1983) offers a
supplementary explanation suggesting that stock prices signal changes in expected inflation
because money supply responds to changes in expected real activity. Mandelker and Tandon
4
(1985) tests whether the negative relationship between real stock returns and inflation in the
United States is in fact proxying for a positive relationship between stock returns and real
activity variables in six major industrial countries over 1966–1979. Hendry’s (1986) approach
which allows making inferences to the short-run relationship between macroeconomic variables
as well as the long-run adjustment to equilibrium, they analysed the influence of interest rate,
inflation, money supply, exchange rate and real activity, along with a dummy variable to capture
the impact of the 1997 Asian financial crisis. Chen, Roll and Ross (1986), having first illustrated
that economic forces affect discount rates, the ability of firms to generate cash flows, and future
dividend payouts, provided the basis for the belief that a long-term equilibrium existed between
stock prices and macroeconomic variables. Darrat and Mukherjee (1987) finds a significant
causal (lagged) relationship between stock returns and some selected macro variables, including
money supply, implying market inefficiency in the semi-strong sense on the Indian data over
1948–1984. Fama and French (1989) finds that expected returns on common stocks and long-
term bonds contain a term or maturity premium that has a clear business-cycle pattern (low near
peaks, high near troughs). Expected returns also contain a risk premium that is related to longer-
term aspects of business conditions. The variation through time in this premium is stronger for
low-grade bonds than for high-grade bonds and stronger for stocks than for bonds. The general
message is that expected returns are lower when economic conditions are strong and higher when
conditions are weak. Asprem (1989) investigates the relationship between stock indices, asset
portfolios and macroeconomic variables in ten European countries. It is shown that employment,
imports, inflation and interest rates are inversely related to stock prices. Expectations about
future real activity, measures for money and the U.S. yield curve are positively related to stock
prices. Schwert, 1989 in analyzes the relation of stock volatility with real and nominal
macroeconomic volatility, economic activity, financial leverage, and stock trading activity using
monthly data from 1857 to 1987. Ferson and Harvey (1991) provides an analysis of the
predictable components of monthly common stock and bond portfolio return. Most of the
predictability is associated with sensitivity to economic variables in a rational asset pricing
model with multiple betas. The stock market risk premium is the most important for capturing
predictable variation of the stock portfolios, while premiums associated with interest rate risks
capture predictability of the bond returns. Time variation in the premium for beta risk is more
important than changes in the betas. Lee (1992) investigates causal relations and dynamic
interactions among asset returns, real activity, and inflation in the postwar United States. Major
findings are (1) stock returns appear Granger-causally prior and help explain real activity, (2)
with interest rates in the VAR, stock returns explain little variation in inflation, although interest
rates explain a substantial fraction of the variation in inflation, and (3) inflation explains little
variation in real activity. Mukherjee and Naka (1995) investigates whether cointegration exists
between the Tokyo Stock Exchange index and six Japanese macroeconomic variables, namely
the exchange rate, money supply, inflation, industrial production, long-term government bond
rate, and call money rate. They find that a cointegrating relation indeed exists and that stock
prices contribute to this relation. Chatrath et al. (1997) investigates a negative relationship
5
between stock market returns and inflationary trends has been widely documented for developed
economies in Europe and North America. This study provides similar evidence for India. Naka
A., Mukherjee T. and Tufte D. (1998) analyze relationships among selected macroeconomic
variables and the Indian stock market. They find that three long-term equilibrium relationships
exist among these variables. These results suggest that domestic inflation is the most severe
deterrent to Indian stock market performance, and domestic output growth is its predominant
driving force. After accounting for macroeconomic factors, the Indian market still appears to be
drawn downward by a residual negative trend. Ibrahim (1999) investigates the dynamic
interactions between seven macroeconomic variables and the stock prices for an emerging
market, Malaysia. The results strongly suggest informational inefficiency in the Malaysian
market. The bivariate analysis suggests cointegration between the stock prices and three
macroeconomic variables - consumer prices, credit aggregates and official reserves. From
bivariate error-correction models, we note the reactions of the stock prices to deviations from the
long run equilibrium. Gjerde & Saettem, 1999 investigates to what extent important results on
relations among stock returns and macroeconomic factors from major markets are valid in a
small, open economy. Wongbangpo and Sharma (2002) investigates the role of select
macroeconomic variables, i.e., GNP, the consumer price index, the money supply, the interest
rate, and the exchange rate on the stock prices in five ASEAN countries (Indonesia, Malaysia,
Philippines, Singapore, and Thailand). They observe long and short term relationships between
stock prices and these macroeconomic variables. Vuyyuri (2005) investigates the cointegration
relationship and the causality between the financial and the real sectors of the Indian economy
using monthly observations from 1992 through December 2002.
Different methods of data analysis have been put into use by the researchers in their studies
about the effect of macroeconomic variables on economy in the case of India, Sri Lanka, U.S.,
U.K., Canada, Germany, Netherland, Switzerland, European countries and ASEAN countries
with each other or with country(s) from the other parts of the world. Granger’s Causality Model,
Cointegration techniques (particularly Johansen’s Model), VECM and Vector Auto Regression
Model are the prominent ones that have been used to analyze the data about the effect of
macroeconomic variables on economy. However, a number of researches have used only one or
at the most two methods to analyze the data.
Granger’s causality model has also been used very extensively by the researchers. Darrat and
Mukherjee (1987) , Wongbangpo and Sharma (2002), Ibrahim (1999), Vuyyuri (2005) applying
Granger-type causality. Ibrahim (1999), Wongbangpo and Sharma (2002) Cheung and Ng
(1998), Vuyyuri (2005), Johansen, S. & Juselius, K. 1990 using the Johansen cointegration
technique using cointegration. Ferson and Harvey (1991) using rational asset pricing model with
multiple betas. James et al. (1985) ,Lee (1992), Gjerde & Saettem, 1999 Using a multivariate
vector autoregression (VAR) approach, uses a VARMA approach. Mukherjee and Naka (1995),
Naka A., Mukherjee T. and Tufte D. (1998) use Johansen's (1991) vector error correction model
(VECM) .Chatrath et al. (1997) using heteroscedasticity and autocorrelation corrected models.
6
The current study contributes to the literature in numerous ways. First, this is the study
concentrating on the economy India and Sri Lanka; and studies the linkages within these rather
than with the developed world. Secondly, it uses a combination of the various methods used
empirically to analyze the data.
4. Research Methodology
In this study monthly data from 2002 onwards to 2009 has been used in case of all the variables
like, GDP (Gross Domestic Product), GNI (Gross National Income), wholesale price index
(WPI), consumer price index (CPI), exchange rates, bank rates and balance of payments. The
major source of data of all the above macro economic variables is International Monetary Fund
on-line data source. Index Numbers (2000=100) is used as the base index for the whole research
data. We filled the missing values by taking the average of two of the preceding cases and two of
the succeeding cases.
Data have been analyzed using econometric tools. The analysis of econometrics can be
performed on a series of stationary nature. In order to check whether or not the series are
stationary, we prepare the line graph for each of the series. Further, we perform the Augmented
Dickey-Fuller test under the unit root test to finally confirm whether or not the series are
stationary. For the basic understanding of Unit root testing, we may look at the following
equation
yt = ρ yt–1 + xt′δ + εt , (1.1)
where xt are optional exogenous regressors which may consist of constant, or a constant and
trend, ρ and δ are parameters to be estimated, and the εt are assumed to be white noise. If |ρ| 1 ,
y is a nonstationary series and the variance of y increases with time and approaches infinity. If
|ρ|< 1 , y is a (trend-)stationary series. Thus, we evaluate the hypothesis of (trend-) stationarity
by testing whether the absolute value of |ρ| is strictly less than one.
The Standard Dickey-Fuller test is carried out by estimating equation (1.2) after subtracting yt-1
from both sides of the equation.
∆yt = α y t-1 + xt′δ + εt, (1.2)
where α = ρ - 1. The null and alternative hypotheses may be written as,
H0 : α = 0
H1: α < 0 (1.3)
In order to make the series stationary, we take the log of the three series and arrive at the daily
return of the three series. All the remaining analysis is performed at the daily return (log of the
series) of WPI, CPI and Exchange rates.
At the stationary log series of the three stock exchanges, we perform the Granger’s causality
model in order to observe (i) whether the LOG of WPI granger causes the LOG of Exchange rate
and/or at CPI; (ii) whether the LOG of Exchange rate granger causes the return at LOG of CPI
7
and/or at LOG of WPI; and (iii) whether the LOG of CPI granger causes the LOG of WPI and/or
at Exchange Rate.
The Granger (1969) approach to the question of whether x causes y is to see how much of the
current y can be explained by past values of y and then to see whether adding lagged values of x
can improve the explanation. y is said to be Granger-caused by x if x helps in the prediction of y
, or equivalently if the coefficients on the lagged x ’s are statistically significant. It is pertinent to
note that two-way causation is frequently the case; x Granger causes y and y Granger causes x. It
is important to note that the statement “x Granger causes y” does not imply that y is the effect or
the result of x. Granger causality measures precedence and information content but does not by
itself indicate causality in the more common use of the term. In Granger’s Causality, there are
bivariate regressions of the under-mentioned form –
yt = α0 + α1 yt-1 + …… + αl yt-l + β1 xt-1 + …… + βl xt-l + εt
xt = α0 + α1 xt-1 + …… + αl xt-l + β1 yt-1 + …… + βl yt-l + t (1.4)
for all possible pairs of (x, y) series in the group. In equation (1.4), we take lags ranging from 1
to l. In Granger’s model, one can pick a lag length, l that corresponds to reasonable beliefs about
the longest time over which one of the variables could help predict the other. The reported F-
statistics are the Wald statistics for the joint hypothesis:
β1 = β2 = ………= βt = 0 (1.5)
for each equation. The null hypothesis is that x does not Granger-cause y in the first regression
and that y does not Granger-cause x in the second regression.
We follow the application of Granger’s causality with the Vector Auto Regression (VAR)
Model. The Vector Auto Regression (VAR) is commonly used for forecasting systems of
interrelated time series and for analyzing the dynamic impact of random disturbances on the
system of variables. The VAR approach sidesteps the need for structural modeling by treating
every endogenous variable in the system as a function of the lagged values of all of the
endogenous variables in the system. The mathematical representation of a VAR is:
yt = A1 y t-1 + …… + Ap y t-p + Bxt + εt (1.6)
where yt is a k vector of endogenous variables, xt is a d vector of exogenous variables, A1,
…… , Ap and B are matrices of coefficients to be estimated, and εt is a vector of innovations
that may be contemporaneously correlated but are uncorrelated with their own lagged values and
uncorrelated with all of the right-hand side variables.
Finally, we apply the Variance Decomposition Analysis in order to finally quantify the extent
upto which the three indices are influenced by each other. While impulse response functions
trace the effects of a shock to one endogenous variable on to the other variables in the VAR,
variance decomposition separates the variation in an endogenous variable into the component
shocks to the VAR. Thus, the variance decomposition provides information about the relative
importance of each random innovation in affecting the variables in the VAR.
8
Table 5.1
From the above table in which descriptive values of all the variables have been calculated shows
that standard deviation is very high in case of GNI comparative to others which portrays nothing
but that it is dispersed around its mean value by 13346.42 i.e., there is high volatility in its
values. From the skewness measure we found that exchange rates and balance of payment is
negatively skewed while bank rates are more positively skewed compared to other variables. In
case of kurtosis, all variables are negatively skewed except bank rates and balance of payments.
Next step is to check out the correlation between the variables in consideration in this study.
.Table 5.2
In the table 5.2 there is a positive correlation between Exchange rates - Bank rates, Exchange
rates-Balance of payments, Bank rates - Balance of payments, W.P.I. - C.P.I., WPI - G.D.P.,
WPI-GNI, CPI - GDP and CPI-GNI.
In the same table there is a negative correlation between Exchange rates - WPI, Exchange rates -
CPI, Exchange rates-GDP, Exchange rates – GNI, Bank Rates -WPI, Bank Rates -CPI, Bank
Rates – GDP, Bank Rates – GNI, WPI - Balance of Payments, CPI - Balance of Payments.
Balance of payments - GDP and Balance of payments - GNI. In table highlighted values are
significant at 0.05 level of significance.
Table 5.3
Coefficientsa
Model Unstandardized Coefficients Standardized t Sig.
Coefficients
B Std. Error Beta
1 (Constant) -5371.526 22912.473 -.234 .853
Exchange Rates -7.066 82.443 -.001 -.086 .946
Bank Rates 568.306 1987.636 .004 .286 .823
WPI 23.592 105.386 .031 .224 .860
CPI -16.876 102.537 -.025 -.165 .896
GNI 1.079 .254 1.097 4.244 .147
Balance of Payments 1.298 .263 .110 4.928 .127
a. Dependent Variable: GDP
From table 5.3, we can formulate the regression equation Y= a + bX, where in Y is the
dependent variable (GDP) and X is the independent variable (Exchange rates, Bank rates, WPI,
CPI, GNI and Balance of Payments). Hence, we arrive at the regression equation GDP = -
5371.526 + (-7.066) Exchange Rates + (568.306) Bank Rates + (23.592) WPI + (-16.876)CPI +
(1.079) GNI + (1.298) Balance of Payments. Using this regression equation to the entire series
we find out the predicted values of GDP for the given values of independent variables. These
values shall be presented later in this section.
Table 5.4
b
ANOVA
Model Sum of df Mean Square F Sig.
Squares
a
1 Regression 1.207E9 6 2.012E8 5542.540 .010
Residual 36302.156 1 36302.156
Total 1.207E9 7
a. Predictors: (Constant), Balance of Payments, Exchange rates, Bank Rates, CPI, WPI, GNI
b. Dependent Variable: GDP
10
Table 5.4 shows the anova table in which we find the sum of squares, mean square, f statistic and
level of significance for regression equation as also for the residuals. The first important value
that we can look at is the level of significance the value of which is found to be 0.010. This value
is significant at 5% level of significance. Looking at the sum of squares, we find that the
regression equation accounts for a major proportion of the values of the dependent variable
(GDP). The detailed values of GDP at every level of independent variables are presented in the
table 5.5 below.
Table 5.5
Table 5.6
a
Coefficients
Model Unstandardized Coefficients Standardized Coefficients t Sig.
B Std. Error Beta
1 (Constant) 526.488 21214.056 .025 .984
Exchange Rates -5.809 74.386 -.001 -.078 .950
Bank Rates -198.429 1853.503 -.001 -.107 .932
WPI -1.903 97.361 -.002 -.020 .988
CPI 34.711 87.036 .050 .399 .758
Balance of Payments -1.149 .325 -.096 - .175
3.540
GDP .878 .207 .864 4.244 .147
a. Dependent Variable: GNI
From table 5.6, we can formulate the regression equation Y= a + bX, where in Y is the
dependent variable (GNI) and X is the independent variable (Exchange rates, Bank rates, WPI,
CPI, GDP and Balance of Payments). Hence, we arrive at the regression equation GDP =
526.488 + (-5.809) Exchange Rates + (-198.429) Bank Rates + (-1.903) WPI + (34.711) CPI +
(-1.149) Balance of Payments + (.878) GDP. Using this regression equation to the entire series
we find out the predicted values of GDP for the given values of independent variables. These
values shall be presented later in this section in the table 5.7
Table 5.7
ANOVA
Model Sum of Squares df Mean Square F Sig.
a
1 Regression 1.247E9 6 2.078E8 7040.431 .009
Residual 29516.652 1 29516.652
Total 1.247E9 7
a. Predictors: (Constant), GDP, Exchange Rates, Bank Rates, Balance of Payments, WPI, CPI
b. Dependent Variable: GNI
Table 5.7 shows the anova table in which we find the sum of squares, mean square, f statistic and
level of significance for regression equation as also for the residuals. The first important value
that we can look at is the level of significance the value of which is found to be 0.009. This value
is significant at 5% level of significance. Looking at the sum of squares, we find that the
regression equation accounts for a major proportion of the values of the dependent variable
(GNI). The detailed values of GNI at every level of independent variables are presented in the
table 5.8 below.
12
Table 5.8
From table 5.8, we find that the predicted values in all cases are quite near to the ±1% of the
observed values from year 2002 to 2009, which indicates that there is a significant impact of the
independent variables on the GNI. Besides presenting the predicted values of the series, table 5.8
also presents the residual value, standardized predicted value, standard error of the predicted
value, Mahalanobis distance, deleted residual, and Cook’s distance.
For performing the econometric analysis, it is very essential for the researcher to make sure that
the series under reference are stationary. In order to make the series stationary, we take log of the
three series on which the further analysis shall be performed. In this way, three new variables are
created and we assign those, names LOGExchange, LOGWPI and LOGCPI which denote the
LOG of Exchange rate, WPI and CPI respectively. Going further in the paper, we shall discuss
the linkages between the logs of exchange rate, WPI and CPI
Table 5.9 presents the descriptive statistics of the series of LOGExchange, LOGWPI and
LOGCPI
13
Table 5.9
Descriptive statistics of the Exchange rates, WPI and CPI
Table 5.9 shows that the mean at the Exchange rates, WPI and CPI happens to be 45.4384,
130.7451 and 133.9192 respectively. Since there are a total of 96 observations for a period of 8
years. The value of median is highest in the case of WPI than the CPI and Exchange rates which
are 128.9000, 127.5890 and 45.5355 respectively. The variance and standard deviation in the
case of CPI is higher than the WPI and Exchange rate which shows that the volatility is more in
CPI than the others. In Figure 1 to 4 present the line graphs of the LOG of WPI, LOG of CPI and
LOG of Exchange rate of India. While the return on WPI, CPI and Exchange Rates are
individually presented in figures 1 to 3, figure 4 presents common line graphs for the three macro
economic variables under study.
Figure 1
LOGWPI
.05
.04
.03
.02
.01
.00
-.01
-.02
-.03
-.04
10 20 30 40 50 60 70 80 90
Figure 2
LOGCPI
.08
.04
.00
-.04
-.08
-.12
-.16
10 20 30 40 50 60 70 80 90
15
Figure 3
LOGXCHNG
.12
.08
.04
.00
-.04
-.08
-.12
10 20 30 40 50 60 70 80 90
Figure 4
.12
.08
.04
.00
-.04
-.08
-.12
-.16
10 20 30 40 50 60 70 80 90
The unit-root test is performed on the three series in order to test the null hypothesis that the
series has a unit root. The findings of the unit-root test and the augmented Dickey- Fuller test are
shown below in the following tables.
Table 5.10
Unit root test on LOG exchange
By the way of unit-root test, the null hypothesis that series Log of Exchange Rates has a unit-root
is tested. Probability value of less than 0.05 in above table shows that the Null hypothesis is
rejected and the variable does not have a unit-root, which confirms that the series is stationary.
Hence, the econometric models can now be applied on the series.
Table 5.11
Unit root test on LOG CPI
The probability value of unit-root test in table 5.11 points towards the fact that the null
hypothesis can be rejected at 0.05 level of significance. It implies that the LOG of CPI of India is
also a stationary one. Hence, the econometric models can now be applied on the series.
17
Table 5.12
Unit root test on LOG WPI
The probability value of unit-root test in table 5.12 points towards the fact that the null
hypothesis can be rejected at 0.05 level of significance. It implies that the LOG of WPI of India
is also a stationary one.
Table 5.13
Granger Causality test on India monthly data
Pairwise Granger Causality Tests
Date: 03/11/11 Time: 16:09
Sample: 1 95
Lags: 2
Table 5.13 presents the results about the application of Granger’s Causality model to the WPI,
CPI and Exchange Rates of India. Null hypothesis in the case of Granger’s causality model is
that ‘A’ does not granger cause ‘B’. On those lines, table 6 tests the hypotheses about the three
variables in pairs. The results show that the probability value for the hypotheses ‘Exchange rate
does not Granger Cause LOGCPI’ and ‘LOGCPI does not Granger Cause LOGEXCHNG’ is
more than 0.05 which means that in both the cases null hypotheses can be accepted. And the
same results are observed in the case of LOGWPI & LOGCPI and LOGWPI & LOGEXCHNG.
18
Now we apply the Vector Auto Regression (VAR) model on the series under reference in order
to further confirm the results produced by the Granger’s Causality model.
In table 5.14, we present the application of Vector Auto Regression (VAR) Model at the three
stock exchanges.
Table 5.14
Vector Auto Regression test on India’s monthly data
By the application of VAR Model, we observe that the integration of macroeconomic variables
with the other can be established if the p-value is more than 1.96. Table 5.14 shows that the
LOGCPI at the lag of 1 and 2, does not have any influence on LOGCPI, LOGWPI and
LOGEXCHNG.. Similarly, LOGWPI at a lag of 1 and 2 does not have any influences on the
LOGCPI, LOGWPI and LOGXHNG. In LOGXCHNG, the table reveals that LOGXCHNG at a
lag of 1 and 2 does not have any effect on the LOGCPI, LOGWPI and LOGXCHNG.
Table 5.15
Variance Decomposition on India’s monthly data
Finally, the Variance Decomposition Analysis of the three macro economic variables is
presented in the table 5.15. The table decomposes the values at the three macro economic
variables for a period ranging from 1 to 10.
The Variance Decomposition Analysis as presented in table 5.15. It implies that on LOGCPI, the
impact of other two macro economic variables is negligible. Rather the LOGCPI itself with the
lag of 1 through 10 impacts the LOGCPI in the current period. However, the table reveals that in
the case of LOGWPI, there is visible impact of LOGCPI for periods 1 to 10 and LOGEXCHNG
for the periods 2 to 10. In LOG WPI the impact on LOGCPI is more than the LOGEXCHNG. In
the case of LOGEXCHNG, there is also visible impact of LOGCPI and LOGWPI for the periods
of 2 to 10. The impact is more in the case of LOGCP than the LOGWPI. Variance
Decomposition Analysis shows that the macro economic variables under study are not much
influenced by each other.
5.3 Descriptive Statistics and Correlation matrix of Sri Lanka yearly data
Table 5.16
From the above table in which descriptive values of all the variables have been calculated shows
that standard deviation is very high in case of Balance of Payments comparative to others which
portrays nothing but that it is dispersed around its mean value by 163888 i.e., there is high
volatility in its values. From the skewness measure we found that only balance of payment is
negatively skewed while bank rates are more positively skewed compared to other variables. In
case of kurtosis, all variables are negatively skewed except bank rates and balance of payments.
Next step is to check out the correlation between the variables in consideration in this study.
21
Table 5.17
Correlations
Exchange Bank Rates WPI CPI GDP GNI Balance of
Rates Payments
Exchange Rates 1.00 -0.49 0.92 0.93 0.95 0.95 -0.71
Bank Rates -0.49 1.00 -0.42 -0.44 -0.45 -0.45 0.43
WPI 0.92 -0.42 1.00 0.99 0.99 0.99 -0.88
CPI 0.93 -0.44 0.99 1.00 1.00 1.00 -0.84
GDP 0.95 -0.45 0.99 1.00 1.00 1.00 -0.82
GNI 0.95 -0.45 0.99 1.00 1.00 1.00 -0.81
Balance of Payments -0.71 0.43 -0.88 -0.84 -0.82 -0.81 1.00
In the table 5.17 there is a positive correlation between Exchange rates -WPI, Exchange rates-
CPI, Exchange rates-GDP, Exchange rates- GNI, Bank rates - Balance of payments, W.P.I. -
C.P.I., WPI - G.D.P. and WPI-GNI
In the same table there is a negative correlation between Exchange rates – Balance of Payments,
Exchange rates – Bank Rates, Bank Rates -WPI, Bank Rates -CPI, Bank Rates – GDP, Bank
Rates – GNI, WPI - Balance of Payments, CPI - Balance of Payments, GDP-Balance of
payments and GNI-Balance of payments. In table highlighted values are significant at 0.05 level
of significance.
Table 5.18
a
Coefficients
Model Unstandardized Coefficients Standardized t Sig.
Coefficients
B Std. Error Beta
1 (Constant) -199957.986 227360.801 -.879 .541
xchnge -203.156 1830.257 -.001 -.111 .930
Bank Rates 4508.881 1747.712 .004 2.580 .235
WPI -854.678 599.947 -.043 -1.425 .390
CPI 3164.948 1370.841 .136 2.309 .260
GNI .911 .046 .893 19.712 .032
Balance of Payments -.151 .040 -.021 -3.750 .166
a. Dependent Variable: GDP
22
From table 5.18, we can formulate the regression equation Y= a + bX, where in Y is the
dependent variable (GDP) and X is the independent variable (Exchange rates, Bank rates,
WPI, CPI, GNI and Balance of Payments). Hence, we arrive at the regression equation GDP
= -199957.986 + (-203.156) Exchange Rates + (4508.881) Bank Rates + (-854.678) WPI
+ (3164.948) CPI + (0.911) GNI + (-0.151) Balance of Payments. Using this regression
equation to the entire series we find out the predicted values of GDP for the given values of
independent variables. These values shall be presented later in this section in the table 5.19
Table 5.19
b
ANOVA
Model Sum of Squares df Mean Square F Sig.
1 Regression 1.003E13 6 1.671E12 185498.790 .002a
Residual 9007333.846 1 9007333.846
Total 1.003E13 7
a. Predictors: (Constant), Balance of Payments, Bank Rates, Exchange Rate, CPI, WPI, GNI
b. Dependent Variable: GDP
Table 5.19 shows the anova table in which we find the sum of squares, mean square, f statistic
and level of significance for regression equation as also for the residuals. The first important
value that we can look at is the level of significance the value of which is found to be 0.002. This
value is significant at 5% level of significance. Looking at the sum of squares, we find that the
regression equation accounts for a major proportion of the values of the dependent variable
(GDP). The detailed values of GDP at every level of independent variables are presented in the
table 5.20 below.
Table 5.20
Medi
2695731 2696781 249.00 -0.22781 0.082966 2972.344 5.991052 12845.3 5.13798
an
From table 5.20, we find that the predicted values in all cases are quite near to the ±1% of the
observed values from year 2002 to 2009, which indicates that there is a significant impact of the
independent variables on the GDP. Besides presenting the predicted values of the series, table
5.20 also presents the residual value, standardized predicted value, standard error of the predicted
value, Mahalanobis distance, deleted residual, and Cook’s distance.
Table 4.21
a
Coefficients
Model Unstandardized Coefficients Standardized t Sig.
Coefficients
B Std. Error Beta
1 (Constant) 206911.824 259697.553 .797 .572
Exchange Rates 318.889 1994.159 .002 .160 .899
Bank Rates -4890.749 2050.417 -.004 -2.385 .253
WPI 910.217 694.910 .047 1.310 .415
CPI -3392.804 1672.082 -.149 -2.029 .292
GDP 1.095 .056 1.117 19.712 .032
Balance of Payments .164 .050 .023 3.299 .187
a. Dependent Variable: GNI
From table 5.21, we can formulate the regression equation Y= a + bX, where in Y is the
dependent variable (GNI) and X is the independent variable (Exchange rates, Bank rates, WPI,
CPI, GDP and Balance of Payments). Hence, we arrive at the regression equation GDP =
206911.82 + (318.889) Exchange Rates+ (-4890.749)Bank Rates + (910.217)WPI + (-3392.804)
CPI+ (0.164) Balance of Payments + (1.095) GDP. Using this regression equation to the entire
series we find out the predicted values of GDP for the given values of independent variables.
These values shall be presented later in this section in the table 5.22
Table 5.22
b
ANOVA
Model Sum of Df Mean Square F Sig.
Squares
a
1 Regression 9.645E12 6 1.608E12 148397.650 .002
Residual 1.083E7 1 1.083E7
Total 9.645E12 7
a. Predictors: (Constant), Balance of Payments, Bank Rates, Exchange Rates, CPI, WPI, GDP
b. Dependent Variable: GNI
Table 5.22 shows the anova table in which we find the sum of squares, mean square, f statistic
and level of significance for regression equation as also for the residuals. The first important
24
value that we can look at is the level of significance the value of which is found to be 0.002. This
value is significant at 5% level of significance. Looking at the sum of squares, we find that the
regression equation accounts for a major proportion of the values of the dependent variable
(GNI). The detailed values of GNI at every level of independent variables are presented in the
table 5.23 below.
Table 5.23
Predicted & Residual Values
Observe Mahalanobi
Predicted - Standard - Standard - Std.Err. - Deleted - Cook's -
d- Residual s-
Value Pred. v. Residual Pred.Val Residual Distance
Value Distance
2002 1611994 1611994 0.00 -1.12107 0.000000 3291.318 6.125000
2003 1805933 1807137 -1204.38 -0.95482 -0.365925 3063.022 5.187599 -8993.6 0.92383
2004 2070109 2071006 -896.50 -0.73003 -0.272383 3166.860 5.605616 -12082.6 1.78238
2005 2422733 2419899 2833.75 -0.43281 0.860977 1674.103 0.936018 3822.8 0.04986
2006 2898256 2898750 -494.00 -0.02487 -0.150092 3254.051 5.967379 -21938.7 6.20429
2007 3539634 3539288 346.25 0.52080 0.105201 3273.043 6.047486 31268.5 12.75083
2008 4305650 4306024 -373.50 1.17399 -0.113480 3270.067 6.034900 -29017.7 10.96132
2009 4769271 4769483 -212.00 1.56881 -0.064412 3284.493 6.096002 -51176.1 34.39450
Min. 1611994 1611994 -1204.38 -1.12107 -0.365925 1674.103 0.936018 -51176.1 0.04986
Max. 4769271 4769483 2833.75 1.56881 0.860977 3291.318 6.125000 31268.5 34.39450
Mean 2927948 2927948 -0.05 -0.00000 -0.000014 3034.620 5.250000 -12588.2 9.58100
Medi
2660495 2659325 -292.75 -0.22884 -0.088946 3262.059 6.001139 -12082.6 6.20429
an
From table 5.23, we find that the predicted values in all cases are quite near to the ±1% of the
observed values from year 2002 to 2009, which indicates that there is a significant impact of the
independent variables on the GNI. Besides presenting the predicted values of the series, table
5.23 also presents the residual value, standardized predicted value, standard error of the predicted
value, Mahalanobis distance, deleted residual, and Cook’s distance.
25
LOGWPI
.15
.10
.05
.00
-.05
-.10
-.15
-.20
-.25
-.30
10 20 30 40 50 60 70 80 90
26
Figure 6
DCPI
.08
.04
.00
-.04
-.08
-.12
-.16
10 20 30 40 50 60 70 80 90
Figure 7
LO GEXC HNG
.04
.02
.00
-.02
-.04
-.06
10 20 30 40 50 60 70 80 90
27
Figure 8
.15
.10
.05
.00
-.05
-.10
-.15
-.20
-.25
-.30
10 20 30 40 50 60 70 80 90
Figures 5 to 8 demonstrate the value of the three macro economic variables. It is indicated from
the figures that values at all the three macro economic variables are stationary in nature. In order
to further check the stationarity of the three series, we perform the Unit Root Test in order to
further confirm the same.
The unit-root test is performed on the three series in order to test the null hypothesis that the
series has a unit root. The findings of the unit-root test and the augmented Dickey-Fuller test are
shown below in Table 5.25
Table 5.25
Unit Root test on CPI
The probability value of unit-root test in table 5.25 points towards the fact that the null
hypothesis can be rejected at 0.05 level of significance. It implies that LOG of CPI of Sri Lanka
is also a stationary one. Hence, the econometric models can now be applied on the series..
Table 5.26
Unit root test on WPI
The probability value of unit-root test in table 5.26 points towards the fact that the null
hypothesis can be rejected at 0.05 level of significance. It implies that the LOG of WPI of Sri
Lanka is also a stationary one. Hence, the econometric models can now be applied on the series..
Table 5.27
Unit Root Test on Exchange Rates
The probability value of unit-root test in table 5.27, points towards the fact that the null
hypothesis can be rejected at 0.05 level of significance. It implies that the LOG of Exchange
29
Rate of Sri Lanka is also a stationary one. Hence, the econometric models can now be applied on
the series.
Table 5.28
Granger Causality test on Sri Lanka monthly data
Lags: 2
Table 5.28 presents the results about the application of Granger’s Causality model to the WPI,
CPI and Exchange Rates of India. Null hypothesis in the case of Granger’s causality model is
that ‘A’ does not granger cause ‘B’. On those lines, table 5.28 tests the hypotheses about the
three variables in pairs. The results show that the probability value for the hypotheses ‘Exchange
rate does not Granger Cause LOGCPI’ and ‘LOGCPI does not Granger Cause LOGEXCHNG’ is
more than 0.05 which means that in both the cases null hypotheses can be accepted. And the
same results are observed in the case of LOGWPI & LOGCPI and LOGWPI & LOGEXCHNG.
Now we apply the Vector Auto Regression (VAR) model on the series under reference in order
to further confirm the results produced by the Granger’s Causality model.
In table 5.29, we present the application of Vector Auto Regression (VAR) Model at the three
stock exchanges.
Table 5.29
Vector Auto Regression test on Sri Lanka’s monthly data
By the application of VAR Model, we observe that the integration of macroeconomic variables
with the other can be established if the p-value is more than 1.96. Table 5.29 shows that the
LOGCPI at the lag of 1 and 2, does not have any influence on LOGWPI and LOGEXCHNG.
However, it influences the returns at LOGCPI in period 0. Similarly, LOGEXCHNG at a lag of 1
and 2 does not have any influences on the LOGCPI, LOGWPI and LOGEXHNG. In LOGWPI at
the lag 1 does not have any influence on LOGCPI and LOGEXCHNG but it influences the return
at LOGWPI in period 0. In LOGWPI at lag 2 LOGWPI have influence on LOGCPI but it does
not influence LOGEXCHNG and LOGWPI.
31
Table 5.30
Variance Decomposition on Sri Lanka’s monthly data
Variance Decomposition of LOGCPI_NA:
Period S.E. LOGCPI_NA LOGEXCHNG_NA LOGWPI_NA
1 0.022772 100.0000 0.000000 0.000000
2 0.024161 96.51089 2.261100 1.228008
3 0.025031 93.01309 2.117113 4.869802
4 0.025200 92.95173 2.168757 4.879512
5 0.025229 92.76467 2.180776 5.054553
6 0.025245 92.75595 2.185437 5.058613
7 0.025246 92.75185 2.185334 5.062813
8 0.025247 92.74894 2.186027 5.065036
9 0.025247 92.74892 2.186094 5.064990
10 0.025247 92.74873 2.186116 5.065150
Variance Decomposition of
LOGEXCHNG_NA:
Period S.E. LOGCPI_NA LOGEXCHNG_NA LOGWPI_NA
1 0.009882 0.544881 99.45512 0.000000
2 0.010166 0.697640 97.82953 1.472829
3 0.010253 0.856835 96.17923 2.963936
4 0.010256 0.857207 96.16613 2.976659
5 0.010260 0.867678 96.15021 2.982117
6 0.010260 0.870224 96.14645 2.983325
7 0.010260 0.870247 96.14643 2.983320
8 0.010260 0.870455 96.14619 2.983358
9 0.010260 0.870466 96.14618 2.983358
10 0.010260 0.870471 96.14617 2.983359
Variance Decomposition of LOGWPI_N
Period S.E. LOGCPI_NA LOGEXCHNG_NA LOGWPI_NA
1 0.038559 0.225725 0.001937 99.77234
2 0.039644 0.763915 0.178602 99.05748
3 0.040088 0.749457 1.943572 97.30697
4 0.040104 0.766544 1.947060 97.28640
5 0.040110 0.767313 1.946547 97.28614
6 0.040110 0.768456 1.946880 97.28466
7 0.040110 0.768456 1.947305 97.28424
8 0.040110 0.768561 1.947306 97.28413
9 0.040110 0.768578 1.947306 97.28412
10 0.040110 0.768580 1.947308 97.28411
Cholesky Ordering: LOGCPI_NA
LOGEXCHNG_NA LOGWPI_NA
Finally, the Variance Decomposition Analysis of the three macro economic variables is
presented in the table 5.30. The table decomposes the values at the three macro economic
variables for a period ranging from 1 to 10.
The Variance Decomposition Analysis as presented in table 5.30. It implies that on LOGCPI, the
impact of other two macro economic variables is visible. The impact is near about constant in the
LOG of Exchange rate but in LOG of WPI impact increases step by step than the previous one.
32
However, the table reveals that in the case of LOGEXCHNG, there is visible impact of LOGWPI
for periods 2 to 10 and no impact on LOGCPI. In the case of LOGWPI, there is also visible
impact of LOGEXCHNG for the periods of 3 to 10. Variance Decomposition Analysis shows
that the macro economic variables under study are not much influenced by each other.
Conclusion
The aim of this research is to find out the impact of macroeconomic variables on GDP growth
and study the pattern of CPI, WPI, GDP, GNI and Rate of interest in India and Sri Lanka. To
solve this basic purpose monthly data was used from 2002 to 2009 of both of the countries and
the basic and believed to be “indicator” variables were used and studied and analyzed by first
applying the basic statistical tools like correlation and descriptive statistical tools and finally
regression, unit root test, Granger causality, VAR and Variance decomposition models.
The application of Unit-root test (Augmented Dickey-Fuller test) reveals that the null hypothesis
can be rejected at 0.05 level of significance. It implies that the series of WPI, CPI and Exchange
rates of India and Sri Lanka are stationary. Granger’s Causality Model when applied to the three
series indicates that probability value for the hypotheses ‘Exchange rate does not Granger Cause
LOGCPI’ and ‘LOGCPI does not Granger Cause LOGEXCHNG’ in Indian data and the
probability value for the hypotheses ‘Exchange rate does not Granger Cause LOGCPI’ and
‘LOGCPI does not Granger Cause LOGEXCHNG’ is more than 0.05 which means that in both
the cases null hypotheses can be accepted. And the same results are observed in the case of Sri
Lanka’s data. None of the other variables happen to Granger cause any of the other variables
under study. The application of the VAR model implies that the LOGCPI at the lag of 1 and 2,
does not have any influence on LOGCPI, LOGWPI and LOGEXCHNG. Similarly, LOGWPI at
a lag of 1 and 2 does not have any influence on the LOGCPI, LOGWPI and LOGXHNG. In
LOGXCHNG, the table reveals that LOGXCHNG at a lag of 1 and 2 does not have any effect on
the LOGCPI, LOGWPI and LOGXCHNG in Indian data and in the case of Sri Lanka’s data
Vector Auto regression (VAR) model implies that LOGCPI at the lag of 1 and 2, does not have
any influence on LOGWPI and LOGEXCHNG.. However, it influences the returns at LOGCPI
in period 0.Similarly, LOGEXCHNG at a lag of 1 and 2 does not have any influences on the
LOGCPI, LOGWPI and LOGEXHNG. In LOGWPI at the lag 1 does not have any influence on
LOGCPI and LOGEXCHNG but it influences the return at LOGWPI in period 0. In LOGWPI at
lag 2 LOGWPI have influence on LOGCPI but it does not influence LOGEXCHNG and
LOGWPI. The Variance Decomposition Analysis implies that on LOGCPI, the impact of other
two macro economic variables is negligible. Rather the LOGCPI itself with the lag of 1 through
10 impacts the LOGCPI in the current period. However, in the case of LOGWPI, there is visible
impact of LOGCPI for periods 1 to 10 and LOGEXCHNG for the periods 2 to 10. In LOG WPI
the impact on LOGCPI is more than the LOGEXCHNG. In the case of LOGEXCHNG, there is
also visible impact of LOGCPI and LOGWPI for the periods of 2 to 10. The impact is more in
33
the case of LOGCP than the LOGWPI. In case of Sri Lanka data it implies that on LOGCPI, the
impact of other two macro economic variables is visible. The impact is near about constant in the
LOG of Exchange rate but in LOG of WPI impact increases step by step than the previous one.
However, the table reveals that in the case of LOGEXCHNG, there is visible impact of LOGWPI
for periods 2 to 10 and no impact on LOGCPI. In the case of LOGWPI, there is also visible
impact of LOGEXCHNG for the periods of 3 to 10.
After applying all the models on the data of both the countries the results do not lead us to any
clear-cut conclusion because the results from all the models are different. Granger model and
VAR model indicates that LOGCPI, LOGWPI and LOGEXCHNG does not have any influence
on each other in the case of both of the countries but the Variance decomposition model shows
visible impact of macroeconomic variables on each other in some of the cases in Indian and Sri
Lankan data which is mentioned above.
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