Frequency domain causality analysis of stock market and economic activity in India

- Granger-causality between stock market and economic growth is analyzed in the context of India.
- Conditional-VAR and frequency domain causality tests proposed by Breitung and Candelon (2006) are used.
- Long-run unidirectional causality from stock prices to the industrial production is shown by the conditional model.
- We find insignificant business cycle evidence of the causality from both directions.
- Stock prices are a leading indicator for economic growth in the long-run.

In this study, we analyze the Granger-causality in frequency domain between stock prices and economic growth in India, in order to identify the direction of the causality at different frequencies. For this purpose we use in the first step different seasonal and structural breaks unit root tests. In the second step we use a conditional VAR model as benchmark, and we focus on the conditional and non-conditional frequency domain causality tests. We find evidence of unidirectional causal relationship between stock prices and industrial production in the long-run, running from stock prices to industrial production. When using the non-conditional model, we find evidence of insignificant business cycle causality from both directions. Our study shows that stock prices are a leading indicator for growth in the industrial production in India. In this case, in order to adjust the industrial production in the long-term, the Indian economic policies should be focused with predilection on the stock market environment.