Causality between exchange rates and stock prices. And Fewer Monies, Better Monies.

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Causality between exchange rates and stock
prices. AndFewer Monies, Better Monies.

• Presented by
• Scott Grierson

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Exchange rates and stock prices

• It has been argued that a change in ER could
  change SP because variations in ER alters firms
  profits and thus affects stock prices.
• An increase in domestic SP will create an
  increase in domestic wealth, leading to an
  increase in the demand for money and hence an
  increase in interest rates, which affects ER.

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outline

• 1. Granger causality test
• 2. Data
• 3. Methodology
• 4. Empirical results and conclusions

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Granger Causality

• This model follows Toda and Yamamoto example and
  employs a Granger non-causality test.
• Non experimental data
• Granger causality is when a set a variables Zt is
  caused by Xt if, in the granger sense, the
  information in Xt helps improve the forecasting
  accuracy of Zt.

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data

• The data for this study are monthly nominal
  effective exchange rates and stock prices
  covering the period 1993-1998.
• During this period there is a floating exchange
  rate regime.

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Methodology

• Using the Granger causality model they employ two
  tests. The first has a null hypothesis that has
  stationarity. The second uses a null hypothesis
  that has non-stationarity.
• Stationarity exists if the first 2 moments of the
  joint distributions of the finite subsequences
  are finite and do not change through time.

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Methodology (cont.)

• The advantage of this procedure is that it does
  not require precise knowledge of integration
  properties of the system
• It can be applied even when there is no
  integration and/or stability and rank conditions
  are not satisfied, so long as the order of
  integration of the process does not exceed the
  true lag length of the model. (Toda and Yamamoto)

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Results and Conclusions

• They analyzed the relationship between SP and ER
  using there 2 tests for stationarity.
• The results indicated that only SP granger-cause
  effective ER.

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Conclusions and Results

• It is also revealed that in increase in Swedish
  SP is associated with an appreciation of Swedish
  currency (krona).
• The direction of causality in this model runs
  from SP to ER.

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Fewer Monies, Better Monies.

• So much of barbarism, however, still remains in
  the transactions of most civilized nations, that
  almost all independent countries choose to assert
  their nationality by having, to their own
  inconvenience and that of their neighbors, a
  peculiar currency of their own (John Stuart
  Mill, 1894)

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Introduction

• In many emerging economies we observe
  independence of central banks and where rates are
  flexible some version of an inflation-targeting
  policy approach.
• With the emergence of the EU and adoption of the
  Euro there are still many large countries that
  remain attached to discretionary exchange rate
  regimes.

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1st argument

• Loss of sovereignty.
• The only economic argument form this stance is
  the quality of money. This argument does not
  hold since in todays society the quality, not
  value, of a dollar is equivalent to that of a
  Euro.
• The argument of national pride is not an economic
  argument and will not be discussed further.

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2nd argument

• Loss of seigniorage.
• The inability to pursue an optimal inflation
  strategy to extract maximum revenue limits public
  sector revenue and forces either spending cuts or
  recourse to possibly more distortionary forms of
  taxation.
• An important offset to this is the reduction in
  public debt service costs that result from
  reduced interest rates.
• They assume this factor to be more significant
  than the 1 percent or so of GDP in seigniorage
  loss.

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3rd Argument

• Loss of monetary policy.
• If money creation is tightly and mechanically
  linked to reserve flows, the external balance and
  not the local central bank determine interest
  rates.
• The response to this argument is that there is no
  central bank in Latin America that can cut
  interest rates lower that in New York. Their
  fondest hope is to get down to these levels and
  the safest way to get there is to give up the
  independence of their home currency.

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4th argument

• Loss of lender of last resort.
• This argument is based on the assumption that the
  central bank, not the treasury or the world
  capital market, is the appropriate lender.
• The lender of last resort issue has to do with
  substituting good credit (not money) for bad
  credit.
• The lender of last resort, more often than not,
  is failed or failing banking policy.

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Last Argument

• Fiscal Preparedness.
• The author does not see how a discretionary
  monetary and exchange rate policy can accommodate
  a lack of good fiscal situation better than a
  fixed rate.
• The belief that inflation and devaluation are
  constructive solutions to a fiscal problem is
  contradicted by much of financial history.