Stock Returns and State-Dependent Effects of Changes in Exchange Rate and Money Supply from Central Banks

Abstract

This study investigates the state-dependent effects of exchange rate movements and money supply shocks on stock market returns using daily stock returns, exchange rate, and variations in money supply data obtained from the databank.worldbank.org website from 1990 to 2022. The stock markets of ten emerging and developed countries were used in the study. The Markov-Switching regression methodology was utilized for this study. The results suggest that for the developed stock markets, in Regime 1, a positive shock to the money supply stimulated a significant rise in the stock returns while in Regime 2, a positive shock to the money supply induced a drop in returns. This suggests that for the developed stock markets, the effect of money supply shock on returns is state-dependent. In the developing stock markets, the coefficient for exchange rate was negative and significant in Regime 1, while it was insignificant in Regime 2. Therefore, the effect of exchange rate on returns is state-dependent in developing countries. Also, the coefficient for volatility in the exchange rate was negative and sizable in both regimes, indicating that the returns effect of volatility is not state-dependent. Basically, each day the exchange rate appreciates, stock returns rises in the developed stock markets while a devaluation policy executed in developing countries stimulated some decline in returns of emerging markets. In both regimes, a rise in money supply shock had positive and significant returns. The effect of money supply on stock returns is not state-dependent. Consequently, developing countries need flexible approaches to managing the variations in the exchange rates and money in circulation. While policymakers in developed markets may need to focus more on reducing volatility rather than adjusting exchange rates to influence stockpiling, those of emerging countries could benefit more from policies that stabilize exchange rates.