TAILIEUCHUNG - The Relationship between Exchange Rates and Stock Prices: Studied in a Multivariate Model

To achieve these objectives the government formulated various strategies. The Minister for Economic Development, stated that “the government has to tackle the most serious problems of mobilizing domestic savings to finance the nation’s investment program if it is to attain the desired goals (Toganivalu, 1978). This statement indicated a need for a mechanism, which can be an intermediary in the savings and investment process. So the development of the stock market was an integral element of the government overall strategy in order to utilize the private sector as the engine for economic growth. Fiji’s stock exchange, the South Pacific Stock. | Issues in Political Economy Vol. 14 August 2005 The Relationship between Exchange Rates and Stock Prices Studied in a Multivariate Model Desislava Dimitrova The College of Wooster In the period November 2003 to February 2004 there was an unambiguous upward trend in the . stock market. Over the same period the . dollar kept depreciating against all major currencies. Analysts kept trying to predict when this downward trend would come to an end based on the . trade deficit. Was not the exchange rate affected by the stock market instead In this paper I study if there is a link between the stock market and exchange rates that might explain fluctuations in either market. I make the case that in the short run an upward trend in the stock market may cause currency depreciation whereas weak currency may cause decline in the stock market. To test these assertions I will use a multivariate open-economy short-run model that allows for simultaneous equilibrium in the goods money foreign exchange and stock markets in two-countries. Specifically I focus on the United States and the United Kingdom over the period January 1990 through August 2004. Establishing the relationship between stock prices and exchange rates is important for a few reasons. First it may affect decisions about monetary and fiscal policy. Gavin 1989 shows that a booming stock market has a positive effect on aggregate demand. If this is large enough expansionary monetary or contractionary fiscal policies that target the interest rate and the real exchange rate will be neutralized. Sometimes policy-makers advocate less expensive currency in order to boost the export sector. They should be aware whether such a policy might depress the stock market. Second the link between the two markets may be used to predict the path of the exchange rate. This will benefit multinational corporations in managing their exposure to foreign contracts and exchange rate risk stabilizing their earnings. Third currency is more

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