On Application of Cointegration and Vector Error Correction Model to Macroeconomic Time Series Data

Abstract

Investment in the stock market is long term in nature. Any development that could affect the stability of the economy usually has serious impact on the stock market performance. This research work examines the impact of some macroeconomic variables (Inflation, Interest and Exchange rates as well as Real Gross Domestic Product) on Nigerian stock market index. The methodologies used are cointegration and vector error correction model using annually data collected from Nigeria stock exchange fact book and Central Bank of Nigeria statistical bulletin (2013). From the results obtained the Augmented Dickey-Fuller (ADF) test reveals that all other macroeconomic indicators were stationary at the first order of difference except for SMI and RGDP that were stationary at the second order of difference, I(2). The Johansen co-integration test shows there are at least three co-integrated variables out of the five economic series considered in this study at 5% level of significance.

The vector error correction models obtained generalised that there exists dynamic relationship between all the macro economic variables, but the four macroeconomic   indicators jointly affect and influence the stock market index.The portmanteau test for residual autocorrelation in the VEC show no autocorrelation is left at lag(1) and VEC(1) is the better specification for analysing the interaction between stock market index and macroeconomic variables. In conclusion, government should implement policies that will reduce inflation rate and poverty level through infrastructural development and improved standard of living. Also, interest rates should be made moderate in order to encourage investment and transactions in stocks in the Nigerian Capital Market. The negative exchange rate shows that the Nigeria economy is readily open for international trade. And finally, the RGDP indicates positive impact with the stock market index.

Keywords: Market Interaction, VEC, Cointegration and Macroeconomic variables.