Why stock exchange is called as the ‘financial barometers’ and development indicators of national economy?
Answers
The stock market has traditionally been viewed as an indicator or "predictor" of the economy. Many believe that large decreases in stock prices are reflective of a future recession, whereas large increases in stock prices suggest future economic growth.
The stock market as an indicator of economic activity, however, does not go without controversy. Skeptics point to the strong economic growth that followed the 1987 stock market crash as reason to doubt the stock market’s predictive ability. Given the controversy that surrounds the stock market as an indicator of future economic activity, it seems relevant to further research this topic.
Theoretical reasons for why stock prices might predict economic activity include the traditional valuation model of stock prices and the "wealth effect." The traditional valuation model of stock prices suggests that stock prices reflect expectations about the future economy, and can therefore predict the economy. The "wealth effect" contends that stock prices lead economic activity by actually causing what happens to the economy.
The purpose of this paper, then, is to evaluate stock prices as a leading indicator of economic activity. Time-series analysis and the notion of "Granger causality" are used in this project to estimate relationships between stock prices and the economy, and to see if they are consistent with theory.
In this paper, we will explore the following questions. First, does the stock market lead the real economy, in the sense that variation in its past values explains some of the variation in the real economy? Second, does the stock market "Granger-cause" the real economy, in which case past values of stock prices improve the prediction of future economic activity? And third, does the real economy "Granger-cause" the stock market, in that past values of economic activity improve the prediction of the stock market?