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There are wide-ranging effects on the economy when currency and stock markets move, whether on the domestic or global economy. The economic growth is significantly affected by market fluctuations resulting from technical factors such as inflation, deflation, demographics of investors and discount rates. Central banks consider exchange rates when it comes to monetary policy, controlling money supply for promoting economic growth by forcing up and down the interest rates depending on the current needs of borrowing and spending. Tighter monetary policy is a result of a strong currency which means higher interest rates. However, this could be a problem as it is attracting investors who are looking to yield their investments, strengthening the currency even further. Fluctuation in markets is affected by various factors including floating exchange rates and what influences exchange rates is the country’s economic performance. The following study aims to investigate several factors affecting fluctuations in stock and currency markets and how that affects the broader Eurozone economies trading economics for studying stock market movements and using data from IMF World Economic Outlook to compare between, Germany and France’s economic activity in response to these factors.
With the 2008-2009 Global Financial Crisis, there was a huge impact on the stock market and the interrelationship between the behavior Germany and France stock markets will be investigated during that period and during calm periods to create a better comprehension of financial shocks transmission in Europe. A study investigates the performance of three stock markets in the Eurozone, France and Germany during the period of financial crisis. The framework of VAR-EGARCH (Vector Autoregressive Exponential General Autoregressive Conditional Heteroscedasticity) was used on stock indices and the study suggests that there was an increase in the interrelationship between these stock markets and with the impact of other factors, drawing a clearer pathway for policymakers in that period of financial crisis (Ben Slimane, Mehanaoui and Kazi, 2013).
Stock market is mainly driven by permanent productivity shocks and monetary policy ensures maintaining price stability which would later on lead to stock market stability. The effect of monetary policy on stock returns is investigated by Christos and Alexandros where they identified the correlation between monetary policy actions and financial asset prices for better perception on the transmission mechanism. Stock prices affect consumption spending, exhibit volatility and boom-bust cycles which may in return affect their fundamental value. The discounted cash flow model suggests that stock prices are equal to the value of expected future net cash flows and what alters the discount rate is the monetary policy influencing economic activity. As monetary policy becomes tighter, discount rates go up and future cash flows go down leading to lower stock prices.
According to the National Bureau of Economic Research, interactions between European and US financial markets is interdependent as bond yields and equity markets in the Euro area is affected by shocks to US short term interest rates. Domestic financial markets interplay in the Eurozone have shown that short term interest rates have no effect on equity markets. There is an observed difference in reaction to domestic interest rates in US and European markets as a 100 basis-point increase in European short term interest rates produces a high appreciation of 5.7% in European exchange rates. On the other hand, the same amount of increase results in 1.7% appreciation of US dollar. This difference is due to the Eurozone having more open economy than the US.
Therefore, the model that will be estimated from data will be a multiple linear regression model allowing the dependence of multiple explanatory variables where several independent variables will be investigated to predict Germany and France’s economic performance separately in response to stock market fluctuations based on inflation, demographic groups and discount rates. The multiple regression model will show how the variation of stock prices is related to our predictor variables and how these variables can be used to explain variation in prices. Time will also be considered as one of the predictor variables as the data is time series.
Yt = α βNt γNt δRt ζfMtf ηPt θIt λAt μGt νCt εt, where ‘Yt’ represents economic growth for time ‘t’, ‘Nt’ – stock returns, ‘Rt’ – discount rate, ‘Mtf’ is a set of dummy variables taking value ‘1’ for country ‘f’ and ‘0’ otherwise, ‘Pt’ – monetary policy ratio, ‘It’ – inflation and ‘At’, ‘Gt’, ‘Ct’ are variables representing demographics age, gender and ethnicity respectively.
Testing the hypotheses at the 1%, 5% and 10% significant levels whether, Germany and France’s economic performance will improve or not during periods of fluctuation as monetary policy is imposed using OECD data.
Tested hypotheses: H0: β = 0; H1: β > 0.
Monetary policy would not describe currency strength according to the null hypothesis (H0) as it would not be a significant explanatory variable. Otherwise, the alternative hypothesis (H1) would suggest that as monetary policy is tightened, currency strength increases, influencing Eurozone economic performance as a result.
Some of the variables in hypothesis from this model will be statistically significant. The expected result could be that the coefficient on inflation will be positive. Meaning, the economic performance will increase with inflation. It is also expected that by imposing a tighter monetary policy, there will be a significant shift of stock returns, encouraging transmission of monetary policy along stock markets. The empirical evidence on the relationship between stock market and monetary policy will show how sensitive the transmission is to the economic conditions and how the effect is in dual manner. Results will indicate that lower stock prices are due to monetary policy tightening given higher discount rate and lower future economic. Furthermore, capitalized future cash flows will cause a decline in stock prices with tight monetary policy. The hypothesis on demographics of investors will show that the demand of equities increases due to a high proportion of middle-aged investors which would increase the valuation multiples.
To conclude, there are several reasons of fluctuations in stock markets and currencies which impact the economic performance in Eurozone. The aim of this study is to determine how monetary policy easing will increase overall economic activity level in positive response to stock prices by comprehending the link between aggregate real economy and monetary policy.
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