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Effect of Macroeconomic Variables on Share Price in the Ghana Stock Exchange

Info: 10073 words (40 pages) Dissertation
Published: 9th Dec 2019

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Tagged: International Studies






The stock market is crucial to every economy. In view of this, the study examines the Macroeconomic determinants of share prices in the Ghana stock exchange over the period of 1990 to 2015. The researcher identified the potential macroeconomic variables that determine the stock market as Inflation, Real exchange rate, interest rate and money supply. After testing for stationarity (unit root) using the augmented Dickey Fuller, the cointegraion test was conducted to test the long-run relationship of the variables having unit roots and then, the OLS technique was used for estimating the parameters in the regression model, and finally, the granger test to check if one variable granger cause the other. The results suggest that there was a positive relationship between the study variables except interest rate. At 5% level of significance, Money supply and Inflation was found to be statistically significant whilst interest rate and real exchange rate were statistically insignificant. The augmented dickey fuller shows that there exists a unit root. The result further indicates that there is evidence of at most one long run relationship between the dependent variable and explanatory variables. From these results, the study recommended that the managers of the economy should implement macroeconomic policies that are conducive to the advancement of the stock market since the study provides evidence to show that changes in these macroeconomic variables (Money supply, Inflation, Interest rate, Exchange rate) elicit movements in the stock market this will in turn benefit investors and give them confidence in investing in the stock market.





Over the previous few decades, the link between macroeconomic variables and the stock market movement and advancement has engulfed the attention of many economic writers and authors. It is often argued that several macroeconomic variables such as, inflation, interest rate, money supply and exchange rate are predominantly the determinants of the share prices in the stock exchange. Others have argued strongly that government financial policies and its influence of macroeconomic variables have had a strong influence in the stock returns (Share price) and the economy in general. And as a result, many economic researchers have been hugely inspired to investigate this link between the stock market and several macro economic variables. (e.g., Maysami & Sims, 2002; Singh, Mehta, & Varsha, 2011; Samadi, Bayani, & Ghalandari, 2012). Obtain

For instance, using the Arbitrage theory developed by Ross (1976), Chen et al. (1986) in which they used some macroeconomic variables to explain stock returns in the US stock markets. They show that industrial production; changes in risk premiums, and changes in the term structure are positively related to the expected stock returns, while both the anticipated and unanticipated inflation rates adversely relate to the expected stock returns. Other researchers who studied the relationship between stock returns and macroeconomic variables in developed countries such as Japan, US, Australia, Canada and other European countries employ co-integration. The increased attention on the subject under review is due to the fact that economic theory considers share prices to be a key measure of changes in economic activities.

In spite of growing movement of capital from the developed to emerging economies and its associated high returns (Ushad et al, 2008; Osinbi, 2004), emerging stock markets have not been well explored. Last year 2016, for example, Ghana’s total foreign equity was US$48.03 million and the initial equity transfer was US$18.08 million compared to 2015 where the total foreign equity was US$244.87 million and the initial equity transfer was US$15.83 million for the last quarter of the year.

To a large extent, researchers have focused on using econometric methods in studying the interaction between macroeconomic variables in determining share prices in the stock market in different countries. However, due to the increased focus on the Ghana stock market in recent times, this study seeks to analyze specifically the relationship that exist among the highly volatile macroeconomic variables and stock market returns

There is a reversal or rather a U-turn relationship between stock prices and the economy. For instance, the stock market may tend to influence the economy as found by Smith (1990) or the economy may influence the stock market (Amadi and Odubo 2002). This is the case of macroeconomic variables and share prices in the stock market. Fundamental analysis beliefs share prices are influenced by some macroeconomic tool or indicators viz; Interest rate, foreign exchange rate, money supply, inflation and other macroeconomic tools that are not mentioned in this study. The study employs a general equilibrium approach, stressing the interrelationship between sectors as central to the understanding of the persistence and changes of macroeconomic time-series. Although, it is quite palpable to understand that stock market reacts in response to various factors ranging from macroeconomic, political and socio-cultural behavior of any country.

The stock market refers to the collection of markets and exchanges where the issuing and trading of equities (Stock of publicly held companies), bonds and other sorts of securities takes place, either through formal exchange or over-the-counter markets. Also known as the equity market, the stock market is one of the most vital components of a free-market economy, as it provides companies with access to capital in exchange for giving investors a slice of ownership.

Having provided a background of the research, this study will however concentrate on specific macroeconomic variables that act as determinant of share prices in the Ghana stock exchange. The study will make use of OLS with selected variables to determine whether macroeconomic variables positively or adversely influence share prices in Ghana, unit root to test for stationarity, cointegration to test the long run relationship of the variables, and granger test to determine whether one variable is useful in forecasting the other. Recommendations will also be made in this research for new and potential investors who are willing to invest in the stock market.



Shares/stocks prices are not just regulated by prerogative of the government but are influenced by factors in the macro economy. This has made authors to in time past recognize the importance of these factors and preoccupied with how this factors interact to regulate the prices of shares in the economy. Some Authors argued that macroeconomic variables are the predominant determinants of share prices. While others have strongly argued against. Therefore, the question about what determines share prices in the economy has become very essential.

This study will tend to examine some of the macroeconomic variables that determine share prices in Ghana and how they consistently interact to regulate the overall price of shares in Ghana economy.



The following are the research questions that are examined through out the course of this study.

  1. What are the macroeconomic variables that determine share price?
  2. What is the short run relationship between macroeconomic variables and share prices in the Ghana stock exchange?
  3. What is the bi-causal relationship between the various variables
  4. What is the long run relationship between macroeconomic variables and share prices in the Ghana stock exchange?


It has become very pertinent that for this research to achieve its general purpose, the following objectives be discussed. Hence, the main objective of this study is to estimate if there is a relationship (positive, negative, neutral) between macroeconomic variables and stock returns in Ghana.

The specific objective of this research is:

  1. To investigate the effect of macroeconomic variables on share prices in Ghana
  2. To determine the short run relationship between the macroeconomic variables and share price.
  3. To estimate the long run relationship between the macroeconomic variables and share price
  4. To determine the bi-causal relationship between the variables using the granger causality test




This study will be useful for the investor who may be able to identify various economic variables that they focus on while investing in the stock market and this will give them an advantage to make sound investment decisions. Research analysts, individual investors, portfolio managers, foreign and institutional investors will also benefit from this study as it will assist them in understanding the overall effect, macroeconomic variables have on share price determination. With more companies willing to go public and trade their shares on the stock exchange in Ghana, this study aims to be a catalogue to shed light on some of the factors that affect the stock market most especially the macroeconomic factors.

Again, in carrying out this study, the researcher has acquired new skills and knowledge that can be used in his profession. This research can enlighten the researcher’s thinking with regard to the reality of life especially as we walk towards the path of the business world.

Finally, this research will tend to provide academic scholars with extra information on the application of methodology in order to identify the dynamic relationship between variables.






The scope of the study will cover policies affecting the Ghana stock market over the years. This study also takes into consideration the overview of the profile of Ghana stock market over the years. This study is not restricted to the Ghana economy and the Ghana stock market, as Stock market analysis has also been carried out in some developing and developed economies all over the world.



The study tends to focus only on 4 macroeconomic variables affecting the determination of share prices in Ghana i.e. Inflation, Foreign exchange rate, Interest rate and Money supply. Though their are other macroeconomic and non macroeconomic factors that determine share prices in Ghana, but are purely not inclusive because of the focus and emphasis of the research.


Justice would be done to this study in chapters. The first chapter shall deal with the study of the background of the subject matter justifying the need for the study. Chapter two will deal with a review of related literature concerning macroeconomic variables and stock market. Chapter three will outline the methodology, which would comprise model specification, sources of data, research design, etc. chapter four shall focus the presentation and analysis of regression results. Chapter five shall highlight the summary of the study, present conclusion and make recommendation.







This part of the research basically concentrates on a review of theoretical studies, conceptual framework as well as empirical studies that investigate the relationship between share prices and the macro economy. The macroeconomic variables selected for this study are; Foreign exchange rate, money supply, inflation, and interest rate.

It is by now widely recognized that a well functioning stock market is crucial to economic growth. As part of the financial economic system, the stock market plays important roles in economic growth. Then the question of what determines share prices in the stock market becomes relevant.

Starting from theoretical framework where theories of different scholars (Fama’s Proxy hypothesis, Inflation and Money illusion theory, Keynesian theory of Inflation, Interest rate and Money supply, efficient market hypothesis) will be considered. Then, an evolution of the Ghana stock exchange will be carefully deliberated on. And thereafter, since it is imperative and pertinent to define some terms to make this research more meaningful, the next segment shall deal with the determinants of share prices in the stock market and their definition. Next is the conceptual analysis and after that, the penultimate segment of this chapter shall consider empirical work of various author/writers on the topic under review. And finally, the last part will give a brief summary of the chapter.






This area primarily focuses on theories propounded by different scholars in the past in their pursuit for determining the effect of the macro economy on the stock market returns.



Numerous theories have surfaced in the area of financial markets. Irving Fisher (1906, 1907, and 1930) was one of the early pioneers in this field. In his mechanism ‘Nature of Capital and Income’ (1906) and ‘Rate of Interest’ (1907) he debated that all capital is ‘circulating’ capital and that, all capital is used up in the production process, and thus a “stock” of capital did not exist. Rather, all “capital” is, in fact, investment. This assumption did not go down well with other experts likes Friedrich Hayek (1941). He argued that how Fisher could settle his theory of investment with the Clarkian theory of production, which triggers the factor market equilibrium.

Harry Markowitz (1952, 1959) also did not agree with Fisher and so came out with what became known as the theory of “Modern Portfolio Theory” (MPT). Markowitz argued that investors seek to minimize risk while striving for the highest return possible. According to him investors will act rationally, always making decisions aimed at maximizing their return for their acceptable level of risk. The theory stressed the importance of portfolios, risk, the correlations between security and diversification. His work changed the fashion people invested. It actually shows us that it is possible for different portfolios have varying levels of risk and return. It is up to each investor to decide how much risk they can handle and then allocate their portfolio according to this decision. Prior to Markowitz’s theories, earlier studies placed emphasis on picking single high-yield stocks without any regard to their effects on portfolios as a whole.

Markowitz’s portfolio theory became a stepping-stone towards the creation of what become known as the Capital Asset Pricing Model. (CAPM)


Modigliani and Cohn (1970), theory states that the real effect of inflation is caused by money illusion. Inflation illusion suggests that when there is a rise in expected inflation, bond yields rise, but because equity investors incorrectly discount real cash flows using nominal rates, the increase in nominal yields leads to under pricing of equities. Bekaert and Engstrom (2007).

Stock market investors fail to understand the effect of inflation on nominal dividend growth rates and extrapolate historical nominal growth rates even in periods of changing inflation. Thus when inflation increases, bond market participants increase nominal interest rates which are used by stock market participants to discount unchanged expectations of future nominal dividends. The dividend-price ratio moves with the nominal bond yield because stock market investors irrationally fail to adjust the nominal growth rate to match the nominal discount rate. This implies that stock prices are undervalued when inflation is high and may become overvalued when inflation falls. The dividend yield that emerges from the interaction of rational and irrational investors is positively correlated with inflation and the long-term nominal interest rate.

The argument hinges on the money demand behavior of rational agents who perceive a fall in economic activity and therefore a decrease in money demand. This causes an excess money stock and therefore inflation. In this sense, measures of real activity should dominate measures of inflation when both are used as explanatory variables for real stock returns in testing the Fisher Hypothesis.


Keynesian theory on inflation proposed that changes in money supply do not directly affect prices and that visible inflation is the result of economic pressures in the economy expressing themselves in prices. Keynesian theory argued that; the government needs to actively intervene to stabilize the economy. Otherwise, the uncertainty caused by unpredictable fluctuations will be very damaging to investment and hence long term economic growth. If demand fluctuates, in the way Keynesian claim, and if the policy of having money supply or inflation rule is adhered to, interest rates must fluctuate. Targeting inflation alone may make it a poor indicator of an economy’s state because the money supply will adapt to changes in the inflationary expectations. This is combated by Taylors rule, which takes into account inflation and either the rate of economic growth or unemployment to get the optimum stability level.


The “Efficient Market Hypothesis” (EMH) was initiated by Samuelson and Mandelbrot: They strongly argued that if markets are operating correctly, then all public information concerning an asset will be channeled immediately into its price. If price changes seem random and thus cannot be forecasted, it is because investors are doing their works. The investment theory that states that it is impossible to “beat the market” because stock market efficiency causes existing share prices to always incorporate and reflect all important information. According to the EMH, this means that stocks always trade at their fair value on stock exchanges, and thus it is difficult for investors to either Buy undervalued stocks or sell stocks for inflated prices. Thus, the crux of the EMH is that it should be impossible to outperform the overall market through expert stock selection or market timing, and that the only way an investor can possibly acquire better returns is by buying riskier investments. (http://envy/cepa.newschool.edu/het/profiles)


















In July 1989, Ghana’s stock market was established as a private “limited by guarantee” company under the Companies Code of 1963 (Act 179). It commenced trading in November 1990 poised to give assurance to private investors who intended investing in Ghana. In April 1994, the company was converted to a public “limited by guarantee” company. Over the years, the GSE has made and continue to make significant strides. Currently, it oversees the trading of 43 companies all listed on the stock exchange. Since its inception, the GSE’s listings have been included in the main index, the GSE All-Share Index. The GSE was the 6th best index performing emerging stock market back in 1993, with Capital appreciation of 116%. It became the best index performing stock market among all emerging markets, gaining 124.3% in its index level. In 1995, partly because of high inflation and interest rates, the index growth was a very disappointing 6.3%. Moreover, in 1997, growth of the index was 42%, which later increased to 868.32 at the end of 1998. The market capitalization of the Ghana stock exchange was about 115,500 billion cedi ($11.5 billion). The market capitalization of the Ghana stock exchange was 131,633.22 billion cedi as of December 31, 2007- It appreciated by 31.84%. At the end of Dec 31, 2016, the market capitalization of all 43 listed firms stood at Ghc52.69 billion. While the composite index increased by 6.35% since January 1, 2017. Historically, the Ghana stock market capitalization reached an all time high of 2440.80 in February 2014 and a record low of 940.04 in Dec 2011. The Ghana stock exchange composite index is a major stock market index which tracks the performance of all companies traded in the Ghana stock exchange.

The stock market in general assumes a critical function in an economy by way of mobilizing resources available domestically and making them available for investing in productive ventures that add value to the economy. This effect is unfortunately not automatic. To realize this benefit, there must be a significant linkage between the economy and the stock market.


This section examines interest rates, money supply, exchange rates and inflation as the main determinants of stock market returns. though there are other determinants of stock market returns but these four were selected based on the general focus of this research.


The interest rate is defined as the price of savings determined by demand and supply of loanable funds (Obura & Anyango, 2016). The interest rate is a function of income. Its primary role is to help mobilize financial resources and ensure the efficient utilization of resources in the promotion of economic growth and advancement (Osoro & Ogeto, 2014). The interest rate can also be defined as the annual price charged by a lender to a borrower in order for the borrower to acquire a loan and is usually expressed as a percentage of the total amount loaned. The neoclassical theory of interest rate states that, the cost of loans for investment by entrepreneurs becomes costly when there is an upshot in interest rates, therefore, investment activities in an economy shrinks as a result (Barnor, 2014).

The interest rate is considered the cost of capital and an increase or a decrease in interest rate may affect the investment decision of the investors (Olweny & Omondi, 2010). Accordingly, Rehman, Sidek and Fauziah (2009) argue that higher interest rates or discount rates would reduce the present value of cash flows, hence a rise in the rate of interest increases the opportunity cost of holding cash, which later on leads to a substitution effect between stocks and other interest bearing securities like bonds. According to Barnor (2014), a rise in interest rate influences investing decisions, thus investors make changes in their investment structure, generally from capital market to fixed income securities


Money supply is the total amount of monetary assets available in an economy at a specific time. Money supply changes are a superior indicator and an important source of information about the future of stock market returns or variability (Barnor, 2014). An increase in money supply leads to economic growth, stock prices would benefit from expansionary monetary policy. In another way, with the increase in money supply, the availability of liquidity at a lower interest rate increases, which can flow into the stock market (Rehman, Sidek & Fauziah, 2009). Humpe and Macmillan (2007) states that stock prices are influenced positively by industrial production and adversely by the money supply.


Exchange rate is the rate at which one currency is being converted into another currency (Mohan & Chitradevi, 2014). Exchange rate changes can affect the relative prices, thereby the competitiveness of domestic and foreign producers. A significant appreciation of the domestic currency makes domestic goods expensive relative to foreign goods resulting in a shift of demand away from domestic to foreign goods. When currency appreciates, in a situation where the country is export-oriented, it is expected that there will be a reduction in the competitiveness of her exports, and would therefore have a negative impact on the domestic stock market (Kirui, Wawire & Perez, 2014).

The appreciation of a country’s currency lowers the cost of imported goods, which in most cases constitute a large part of the production inputs for emerging market countries (Kuwornu, 2012). Accordingly, when the domestic currency depreciates against foreign currencies, export product prices will decrease and, consequently, the volume of the country’s export will increase, assuming that the demand for this product is elastic (Kuwornu, 2012). From a macro perspective, foreign exchange rate has an effect on the country’s economy whereas from a micro perspective it affects the firms. As such, exchange rate volatility has implications on a country’s financial sector, the stock market to be precise (Obura & Anyango, 2016).


Inflation is an increase in the general price level. Investors in the stock market constantly monitor and worry about the level of inflation. Rising inflation has an insidious effect; stock prices are higher, investors can Buy fewer stocks. Revenues and profits decline and the economy slows for a time until a steady state is reached. Most studies conclude that expected inflation can either positively or adversely impact stocks, depending on the ability to edge and the government’s monetary policy.



The conceptual framework is a graphical or diagrammatic representation of the relationship between variables in the study. Therefore, several authors have explained the connection between the macroeconomic variables and stock market performance theoretically and empirically. In addition, various empirical studies explain that stock market is responsive to changes in exchange rate, inflation rate, money supply, and interest rate and that there is a causal relationship between stock market returns and this variables. Thus, the independent variables for this study are inflation measured using the consumer price index, Interest rates, money supply and exchange rates while the dependent variable was stock market returns measured using average share Price of manufacturing companies in the Ghana stock exchange. The table below shows the conceptual framework for the study.





Source: researcher


The part of the study aims at examining empirically the impact macroeconomic variables have on the Ghanaian stock market and other stock markets across the world. This impact can be explained using the Present Value Model and the Arbitrage Pricing Theory. These models indicate that, the stock price or return may be influenced by basic macroeconomic factors like gross domestic product, inflation, exchange rate, money supply and so on by the impact of expected dividends, the discount rate or both (Rahman, Abdul, Noor, and Fauziah, 2009). A simple discount model gives indication to the fact that present value of expected future dividends equates the fundamental value of business stock. The future dividends must in the end reflect actual economic activity. Stock prices could closely relate with expected future economic activity if all current, pertinent and existing information are taken into account. Hence, prices of shares are calculated by the expected rate of return and anticipated inflows (Gan, Lee, Yong, and Zhang, 2006; Humpe and Macmillan, 2007;). This suggests that the share price is influenced by economic activities that influence the expected cash inflows and required rate of return.

Meanwhile, Ahmed (2008) looked at the relationships from two different perspectives. First, the stock market as the most major benchmark of economic activity and second, how the stock market possibly impact on the total demand through the total expenditure and savings.




Foreign exchange rate is the value of one currency for the purpose of conversion to another. Foreign exchange rate movements greatly affect the stock price value owing to its information content to the investors. When there are high fluctuations in the foreign exchange rate, the foreign exchange rates movement, the stock value is usually underpriced.

The existence of a relationship between stock prices and exchange rate has received considerable attention. Early studies (Aggarwal, 1981; Soenen and Hennegar, 1988) in this area conceded only the correlation between the two variables—exchange rates and stock returns. Theory explained that a change in the exchange rates would affect a firm’s foreign operation and overall profit which would in turn, affect its stock prices depending on the multinational characteristics of the firm. Conversely, a general downward movement of the stock market will encourage investors to seek for better returns elsewhere. This decrease the demand for money, pushing interest rate down, causing further outflow of funds and hence depreciating the currency. While the theoretical explanation was clear, empirical evidence was mixed. It was Maysami-Koh (2000) who examined the impacts of some macroeconomic variables on the stock returns and concluded that exchange rate is the determinant of the share prices.

Again, Gordon & Guota (2003) and Badu and Prabheesh (2007) claimed bidirectional causality stating that foreign investors have the ability of playing like market maker given their volume of investments. Again in 2004, Griffin stated foreign flows are significant predictor of returns in Thailand, India, Korea, Taiwain and in 2005, Doong et al showed that these financial variables are not co-integrated.

There is paucity of literature on the effect of foreign exchange rate on stock price value. The theoretical postulation states that there is a positive relationship between foreign exchange rate and stock prices. In Ghana’s neighboring country Nigeria, Maku and
Atanda (2010) shows that stock prices and depreciating naira are positively related.

As far as quantifying the expectation of the exchange rate are concerned, Marey (2004) says on the basis of a survey data that long term expectations are not only heterogeneous but are also not effectively described by the rational expectations. In his own research, Marey (2004) tried to investigate the level of plausibility of standard exchange rate expectations mechanism which in an artificial economy are found to be favored by heterogeneous traders, the research concludes that adaptive expectations market exhibits more serial correlation because it bandwagons the expectations market. Secondly, the extrapolative expectations market.

Another study by Tsen (2011) says that the real exchange rate has been found to play an important role in the investment determination and the international trade systems as the appreciation of real exchange rate can lead to retarded exports, a change in the amount of debt payment that needs to be done and a growth of inflow of foreign direct investment. The economies overall can be affected by the changes in the exchange rate.
For this research however, the impact of exchange rate changes on the stock returns has been considered.

For example, the relationship with the US dollar and the Stock Exchange Index has been studied by Wu et al (2012) who have focused their research on the Philippine Stock Exchange. According to the authors, such a research can actually help in guiding the government of countries to macro manage the investor returns on the stocks and thus in effect control the inflow of foreign direct investment into the country. Focusing further on the issue, Bahani-Oskooee and Sohrabian (2006) use the granger causality technique along with the co-integration technique to analyse the results of exchange rates and stock prices by using the S&P 500 index. The result show that not only is the relationship exists only in the short run, it is also bidirectional.

Another study was conducted by Yau and Nieh (2008) note that even though the existence of a relationship is often signified by the researchers between the stock exchange returns and the exchange rates, the length and the direction of the relationship is often an element of further debate. Interestingly, using the granger causality and the relationship between the financial assets and exchange rates of USA and Japan, Yau and Nieh (2008) find that there is no short-term causal relationship between the two however in the long run a positive relationship has been found to exist.











Money supply refers to the total amount of money in circulation or in existence in a country. There are several standard measures of the money supply, including the monetary base, M1, and M2. The monetary base is defined as the sum of currency in circulation and reserve balances (deposits held by banks and other depository institutions in their accounts at the federal reserve). Supply of money affects economic activities and that is why its control has been the primary function of the central monetary authority or central bank of any given economy (Osamonyi 2003). Kevin (2000) classifies the supply of money as a leading indicator. M1 refers to currency in circulation plus demand deposits; while M2 is M1 plus near monies, for example, time deposit. The researchers will adopt M2 for this study. Many studies conducted using data from developed countries, came up with the interesting conclusion that money growth affects stock prices adversely (Davidson and Froyen 1982; Rozeff 1992). The consensus of opinion in this regard proceeds from the reasoning that money growth, except accompanied by growth in output of goods and services, serves to unleash inflationary spiral on the economy, driving stock prices downwards as a consequence; as rational economic agents diversify their wealth holdings away from financial assets (such as stocks and shares) to real (tangible) assets. This strategy is often adapted to hedge against the erosive effect of inflation on financial assets (udegbunam and Oaikheanan 2002)..

Sirucek (2013) explains that the most important factor influencing the advancement of stock prices in the long term is the amount of money in the economy since money supply can affect stock prices directly. Additionally, Shiblee (2009) posits that changes in stock prices are predominantly set by changes in money supply thus an increase in the rate of growth of money supply strengthens the rate of increase in stock prices. Conversely, a fall in the rate of growth of money supply should slow down the growth momentum of stock prices.

Over time, studying this issue has lapsed until the emergence of the Global Financial Crisis, which has been diagnosed as having been caused by liquidity surges that created imbalance in the financial sector and real sector: Ariff et al., (2012).

Bernanke and Kuttner (2005) argue that the price of a stock is a function of its monetary value and the perceived risk in holding the stock. A stock is attractive if the monetary value it bears is high. On the other hand, a stock is unattractive if the perceived risk is high. They believe that tightening the money supply raises the real interest rate which would in turn raise the discount rate and decrease the value of the stock.

According to Kohout (2010), the most important factor influencing the advancement of stock prices in the long term is the amount of money in the economy (i.e. money supply).

According to Maskay (2007) or Chromec (2006) the monetary policy or change in money supply, is one of the most effective tools available to the national central banks of individual countries in association with influencing the actual economic activity. Many authors, such as Keran (1971), Gupta (1974), Musilek (1997), Poire (2002) and Shockstack (2003) consider the money supply as the instrument of the monetary policy, to be the most important macroeconomic factor that influences the behavior and advancement of share prices. Maskay (2007) and Loannids, Kontonikas (2006) consider the stock market to be the basic indicator of the condition and advancement of the economy strongly influencing and preceding it. Also, these authors consider the money supply to be a strong determinant of the stock market, i.e. of the entire economy. Money supply can affect stock prices directly, when there is more money in the economy than can be utilized so they are allocated to investments. But as already mentioned, for example, by using quantitative release results indirectly in the reduction of the interest rates rendering the external financing cheaper, leading to increasing investments i.e. increase in the demand for shares.

Money supply, as the most important macroeconomic factor that affects the stock prices is recognized by Maskay (2007), Dwyer, Hafer (1999), Sprinkel (1964), Poiére (2000), Musílek (1997), Kohout (2010), Nývltová, Režáková ( 2007). According to Veselá (2007) the money supply also acts as the predicting indicator of the advancement of equity prices. There are several theoretical arguments supporting the assumption that the growth of the money supply increases the demand for stocks and hence their prices.

A statement by Gupta (1974) serves as example, when he says that the money supply can be utilized for predicting the advancement of stock markets. His investigation confirmed that 59% of the value of stock indices could be predicted based on the money supply. This statement was supported by, Rapach, Wohar and Rangvid (2005).







The rate of inflation measures the annual percentage increase in prices; the most usual measure is that of retail prices. The government publishes an index of consumer prices each month, and the rate of inflation is the percentage increase in that index over the previous 12 months.

Paragon Pomeyie (2001) defined Inflation as an increase in the price of a basket of goods and services that is representative of the economy as a whole. In other words, inflation is an upward movement in the average level of prices,

Again, According to Shiblee (2009), inflation is defined as a sustained increase in the general level of prices for goods, and services. Thus, inflation is a persistent rise in the overall (or average) level of prices of all goods and services. Inflation occurs when prices of goods increase or when it needs more money to Buy the same items (Saleem, Zafar & Rafique, 2013). Inflation pressure can be largely attributed to structural factors such as; real income reduction caused by fluctuation in oil revenue, high nominal wages and debt obligation in the form of expansionary fiscal deficit (Taofik & Omosola, 2013).

Kuwornu (2012) explored the effect of macroeconomic variables on the Ghanaian stock market returns using monthly data over the period January 1992 to December 2008. The study employed the Johansen Multivariate Co-integration Procedure. The empirical results reveal that there is co-integration between the inflation, crude oil price, exchange rate and 91-day Treasury bill rate and stock returns in Ghana indicating long run equilibrium relationship. Further, the results revealed that; in the short run, Treasury Bill Rate and inflation rate significantly influences the stock returns. In addition, the study found out that in the end the stock returns are significantly influenced by inflation rate, crude oil prices, exchange rate, and the Treasury bill rate.

Higher inflation uncertainty increases the required risk premium, leads to a higher discount rate, and lowers the discounted present value of expected future cash flows, thus resulting in a fall in stock prices. In addition, economic activity is adversely affected by inflation uncertainty and since stock returns lead economic activity, there is a negative relation between stock returns and inflation uncertainty (Azar, 2014). High rates of inflation erode the buying power of an economy’s currency (Mugambi & Okech, 2016). However, low and stable inflation rates allow the private sector to plan for the future, lead to a lower need for costly price adjustments, prevent tax distortion and thus create a stable business environment (Alimi, 2014).

According to Mahedi (2012), based on market efficiency inflation influences stock indices, where; when the inflation rate is higher than expected, which is economically bad news, implies meaningful impact of stock returns.

A study by Alimi (2014) also examined the long run and short run relationships between inflation and the financial sector advancement in Nigeria over the period between 1970 and 2012. The findings of the study found that that inflation presented deleterious effects on financial advancement over the study period. Taofik and Omosola (2013) explored the relationships and dynamic interactions between stock returns and inflation in Nigeria and revealed the existence of a long run relationship between stock returns and inflation. Ahmad and Naseem (2011) examined the impact of high inflation on stock market returns in Pakistan using monthly data of inflation and stock returns and found that there is negative and significant impact of inflation on stock returns.

As a result, stock prices are the reflector of various macroeconomic variables such as inflation, exchange rate, interest rate and industrial production (Aliyu, 2011). Thus, a predictable increase in the rate of inflation slows down financial market development (Owolabi & Adegbite, 2013). According to Azar (2014), stock returns are adversely related to actual inflation, and to expected and unexpected inflation.

The foundation of discourse on the relationship between stock market returns and inflation is the Fisher (1930) hypothesis (Osagie & Emeni, 2015). The Fishers hypothesis presuppose that shares can act as a hedge against inflation during the period of high inflation, investors acquire more of real than financial assets (Mbulawa, 2015)

Stock markets are said to reflect the health of the country’s economy (Sireesha, 2013). The emergence and expansion of stock markets in African countries in recent decades has been an important step for them towards attracting investment that is more private and becoming more integrated into the global financial markets (Balparda, Caporale & Gil- Alana, 2015)

Loannides, Katrakilidis et al. (2002) investigated the relationship between share prices and inflation rate for Greece over the period 1985 to 2000. There were arguments that stock market can hedge inflation in line with Fisher’s hypothesis. Another argument was that, the real stock market was immune to inflation pressures.

Madsen (2004) used Fisher’s hypothesis to estimate the relationship between share returns and inflation. Numerous papers were found that share returns are not hedged against expected inflation and have interpreted this as evidence against the Fisher’s hypothesis. Fisher’s hypothesis was tested for the process of governing inflation, measurement of inflation expectations and the time aggregation of data. The paper demonstrated theoretically and empirically, standard tests of the Fisher hypothesis that can be directly misleading and often do not reveal much about the validity of the fisher’s hypothesis that would be explained by differences in model specification, time aggregation of the data, and Inflation persistence in the data sample and whether instruments have been used for expected inflation. The interaction between model specification and inflation persistence was found to be particularly influential. The more persistent was inflation, the more favorable were estimates, which used nominal share returns as the dependent variable to the Fisher hypothesis.

Kim and Ravi (2006) explained the cross-sectional variation in the relationship between international security returns and expected inflation based on their sensitivities to world stock and bond factors. The paper shows inflation sensitivities of returns on country indexes and international mutual funds on their sensitivities to world and bond indexes. The result from OLS regression coefficient for return sensitivity of stock to the stock market factor was negative and significant at the five percent level. The coefficient for return sensitivity to the bond market factor was positive and significant to the one percent level. Thus, the results support the hypothesis that the inflation sensitivity and positively related to its bond returns sensitivity concluded that, the inflation sensitivity of a security is a positively related to its sensitivity to the world bond index (world stock index).

Wei (2007) investigates the relation between unexpected inflation and stock returns. The study showed correlations between unexpected inflation and nominal equity return of Fama-French book-to-market and size portfolios across the business cycle. The study found four main finding. Firstly, there was strong evidence that share returns respond more undesirably to unexpected inflation during economic contractions than expansions.

Lee (2009) reevaluate whether there is a relationship between share return and the inflation due to inflation rate and reexamining the hypothesis using longer sample period of the US and international data. The inflation illusion hypothesis explained the post-war relation well; it was not compatible with some features of the pre-war relation. A major problem is that while this hypothesis anticipates under pricing stocks with high inflation. Thus, the study observed the overpricing with high inflation in the pre-war period. This implies that although the mispricing components play an important role in the stock market and inflation relation in both subsample periods. The result found that the two types of stock return and inflation relations without imposing a particular permanent and temporary restriction on the two types of shocks. The two major regime hypotheses show positive and negative inflation shocks that can be easily compatible with both pre- and post-war relations in the US.

The effects of inflation on the economy are diverse and can be both positive and negative. The negative effects are however most pronounced and comprise a decrease in the real value of money as well as other monetary variables over time. As a result, uncertainty over future inflation rates may discourage investment and savings, and if inflation levels rise quickly, there may be shortage of goods and as consumers begin to hoard out of anxiety that prices may increase in the future.

Boucher (2004) investigates a new perspective on the relationship between stock prices and inflation, by estimating the common long-term trend in real stock prices, as reflected in the earning-price ratio, and both expected and realized inflation. He studies the role of the transitory deviations from the common trend in the earning-price ratio and realized inflation for predicting stock market fluctuations. In particular, he found that these deviations exhibit substantial in sample and out-of-sample information about future stock returns at short intermediate horizons that is not computed by other popular forecasting variables.

A study by Alimi (2014) also examined the long run and short run relationships between inflation and the financial sector advancement in Nigeria over the period between 1970 and 2012. The findings of the study found that that inflation presented deleterious effects on financial advancement over the study period. Taofik and Omosola (2013) explored the relationships and dynamic interactions between stock returns and inflation in Nigeria and revealed the existence of a long run relationship between stock returns and inflation. Ahmad and Naseem (2011) examined the impact of high inflation on stock market returns in Pakistan using monthly data of inflation and stock returns and found that there is negative and significant impact of inflation on stock returns.

Various theories state that the relationship between these two variables are negative while others feel like the stock market is not at all affected by changes in the rate of inflation. It is unclear whether there exists a negative or positive relationship given the varying conclusions from the literature review.








Interest rate varies with time, default risk, inflation rate, and productivity of capital, amongst others (Chandra 2004). Changes in interest rate encourage substitution between stock market and money markets instruments, and speculative activities. Chandra (2004) submits that a rise in interest rate depress corporate profitability and also leads to an increase in the discount rate applied to equity investors; both of which have adverse impact on stock prices and vice versa. Therefore, a upsurge in interest rate is expected to impact adversely on the performance of the organization.

Gan, Lee, Yong and Zhang (2006) also suggest that there exist a long term negative relationship between stock prices and interest rate. In their study, Liu and Shrestha (2008) examine the long run relationship between interest rate and stock indices in China employing heteroscedastic cointegration analysis and finds that the long term relationship does exist between stock market and interest rates. On the contrary, Pilinkus and Boguslankas (2009) analyse the short run relationships and conclude that short-term interest rates adversely influence on stock market prices.

More recently Alam and Uddin (2009) examined evidence supporting the existence of share market efficiency based on the monthly data between stock index and interest rate for fifteen developed and developing countries and for all of the countries it is found that interest rate has significant negative relationship with share price and for six countries it is found that changes of interest rate has significant negative relationship with changes of share price. They further state if the interest rate is considerably controlled for these countries, it will be the great benefit of these countries’ stock exchange through demand pull way of more investors in share market, and supply push way of more extensional investment of companies.

Few studies have found the existent of long and short run link between stock prices and interest rate. Humpe and Macmillan (2007) document that there exists a long run negative association between long term interest rate and stock prices only in US, using US and Japanese data. In Singapore Maysami, Howe and Hamzah, (2004) also find a negative relationship between long-term interest rate and stock returns while Nasseh and Strauss (2000) find the same relation in six developed countries. However, Ratanapakorn and Sharma (2007) in US find that the stock prices adversely related to the long-term interest rate, while a positive relationship between stock prices and the short-term interest rate is recorded.

A review of Cengiz and Basarir (2014) shows that the study examined the relationship between interest rate and stock market within the framework of real gross domestic product (RGDP) for Turkey for the period 1998-2012 using VAR estimation techniques, and observed that a convincing long run relationship exist between stock market advancement and interest rate. The study also observed that crisis in the stock market is precluded with the control of interest rate in the long run. The study recommended that in making macroeconomic policy aimed at combatting unemployment and their macroeconomic imbalances, policy makers should adjust for the impact of stock market volatility.

The only relevant study to our study on Nigeria was found in Ologunde et al. (2006) who focused on the pattern of the relationship between stock market capitalization rate and interest rate. Their results show that, a significant and positive relationship exist between interest rate and stock market capitalization rate. The study further revealed that government development stock rate has a negative in influence on stock market capitalization rate, though the prevailing interest rate exerts adversely on government development stock rate.

Olweny and Omodi (2011) used both the EGARCH and TGARCH estimation models to examine the effect of some selected macroeconomic variables on stock market based on monthly data sourced from January 2001 and December 2010. The results on interest rate – stock market nexus shows that leverage effects exists between the dual with bad news having signi cant impact on stock return volatility.

The subject matter was also investigated by Kyereboah Coleman and Agyire Tettey (2008). The authors investigated the effect of macroeconomic indicators on the performance of Ghana Stock Exchange. Ghana was used as a case study. The method of data analysis was based on Cointegration and the error correction model. The study revealed the rates on lending as established by commercial banks function as foremost deterrent to the growth of businesses in Ghana. This is because the rate on lending was found to have an indirect influence on stock returns.

Anokye and Tweneboah (2008) conducted a similar work to ascertain the influence of macroeconomic variables on stock returns in the Ghanaian economy. The research focused on both the long run and short run relation concerning the variables in question. The method of analysis was based on Johansen’s multivariate cointegration test and procedures innovation accounting. The study revealed that in Ghana, there is the presence of a long run relation concerning the macroeconomic variables used in the study and stock prices in Ghana. The response of impulse function and decomposition of the error Variance point out that interest rate and direct investment by foreigners tends to be significant influencers of the movements observed in the prices of shares.

Furthermore, Kuwornu and Owusu Nantwi (2011) after examining the subject matter, contented that the influence of interest rate on stock returns have been over exaggerated. The study made use of multiple regression estimated using the ordinary least square estimator and the time series method developed by Box-Jenkins. The results revealed the rates on interest does not influence the returns on stock confirming his hypothesis. The prices of crude on the global market and the exchange rate also did not have any influence on the returns on stock.


 The chapter has reviewed the financial Market theory, the Inflation and  Money illusion hypothesis, efficient market hypothesis and the Keynesian theory on inflation, Interest rate and Money supply. In the Financial Market theory, Irvin Fisher argues that all capital is ‘circulating’ capital and that, all capital is used up in the production process, and thus a “stock” of capital did not exist. Rather, all “capital” is, in fact, investment. This assumption did not go down well with other experts like Friedrich Hayek (1941). He argued that how Fisher could settle his theory of investment with the Clarkian theory of production, which triggers the factor market equilibrium. However, the inflation illusion theory presupposes that if the market suffers from inflation illusion, then holders of rationally priced securities will liquidate their positions and tilt toward underpriced assets while the efficient market hypothesis postulates that stock markets gradually integrate into the world market, and prices react to world information and events like inflation. Thus, the reviewed theoretical explanations provide conflicting views on the effect of macroeconomic variables on stock market returns.

Additionally, most of the reviewed empirical studies show that there is a connection between macroeconomic variables and stock returns. Studies by Pinjaman and Aralas (2015), Barnor (2014), Reddy (2012) and Kuwornu (2012) and some other researchers investigated the relationship between macroeconomic variables on stock market returns and came out with conflicting results. However, this connection and poor connection between macroeconomic variables and stock market is what led to the conduction of this research.























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