Exchange Rate Movements and International Interdependence of Stock Markets

Abstract

Exchange Rate Movements and International Interdependence of Stock Markets

This paper examines linkages between movements of stock prices and movements of exchange rates. In the first part, an empirical analysis using post-1974 data for seven industrialized countries establishes a number of regularities. Thus, nominal stock prices in these countries appear to be significantly correlated. In addition, real stock prices are also similarly correlated. At the same time, however, there appears to be no stable long-run relationship between nominal stock prices and nominal exchange rates.

The second half of the paper constructs and analyzes a theoretical model which is capable of generating patterns of adjustment in real and nominal stock prices and exchange rates that are similar to those found in the data. The fact that short-run movements in stock prices are empirically positively correlated across countries can be used either to place restrictions on the parameter of the theoretical model or to show inferences about the nature of the underlying shocks. For example, in our model, shocks that are positively correlated across countries give rise to similar movements in endogenous variables such as stock prices. In turn, positive correlation of shocks can be the result of either active coordination of policies or of common disturbances such as worldwide productivity shocks. Common movements in stock prices could also come about in response to country-specific shocks provided that the transmission mechanism is appropriately specified. Finally, the model is also able to accommodate the empirical finding pertaining to the lack of a stable relationship between stock prices and nominal exchange rates. The paper concludes with some observations relating to further research in this area.