This paper analyzes long-term equilibrium relationships
between a group of macroeconomic variables and the Karachi Stock
Exchange Index. The macroeconomic variables are represented by the
industrial production index, the consumer price index, M1, and the value
of an investment earning the money market rate. We employ a vector error
correction model to explore such relationships during 1973:1 to 2004:4.
We found that these five variables are cointegrated and two long-term
equilibrium relationships exist among these variables. Our results
indicated a "causal" relationship between the stock market and the
economy. Analysis of our results indicates that industrial production is
the largest positive determinant of Pakistani stock prices, while
inflation is the largest negative determinant of stock prices in
Pakistan. We found that while macroeconomic variables Granger-caused
stock price movements, the reverse causality was observed in case of
industrial production and stock prices. Furthermore, we found that
statistically significant lag lengths between fluctuations in the stock
market and changes in the real economy are relatively short.
