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International Journal of Economic Perspectives, 2017, Volume 11, Issue 2, 665-684.

The Impact of Macroeconomic Variables on an Emerging Economy

Stock Market: Evidence from Jakarta Composite Index, Indonesia

Adenike Adebola ADESANMI*

Cardiff Metropolitan University, UK.

Dadang Prasetyo JATMIKO

Badan Standardisasi Nasional, Indonesia.


The significant growth experienced in the World stock market has been attributed to the development of emerging
markets. This paper investigates the short and long-run equilibrium relationship between macroeconomic
variables, namely; interest rates, inflation, economic growth, exchange rates and Jakarta composite index using
cointegration, vector error correction models and variance decomposition. The paper identifies cointegrating
relationships between selected macroeconomic variables and stock price index. It depicts that these
macroeconomic variables influence the major stock price index in Indonesia in the long-run. The vector error
correction model indicates that selected macroeconomic variables have no significant short-run impact on Jakarta
composite index.

JEL Classifications: C32; E44; F62; G10.

Keywords:Macroeconomic Variables; Stock Market; Emerging Economy; Cointegration Model; Vector Error
Correction Model.

*Corresponding author.


The stock market, as part of the financial system, is very vital to economic development. The stock market
functions as a mediator between savers and borrowers, these lenders and borrowers' preferences are harmonized
through the operation of the market (Nadeem & Zakir, 2009). Financial and economic theories have been
developed over the years; they argue that stock markets are influenced by movement in macroeconomic factors
(Ahmad & Ghazi, 2014). The argument has intensified in the past few years because the stock market is a good
reflection of the domestic economic conditions. Stock market is an important part of the economy as it is the source
for raising large funds from domestic and international investors in the primary market. From an investor's
viewpoint, the existence of the stock market gives the opportunity of entry and exit. When investors are in dire
need of funds or when they decide to diversify their portfolios, the secondary market is readily available for them
to trade investments. Advanced economies have fully explored the benefit of stock markets while emerging
economies are yet to fully usurp the benefits that are derived from sourcing of capital through the stock market
(Asaolu & Ogunmuyiwa, 2011). The significant growth experienced in the World stock market has been attributed
to the development of emerging markets which has increased the attention of academics, individuals and
institutions in emerging stock market.

Indonesia is an emerging economy that is a member of the G-20 and the Next-11 emerging economies. It is the
largest economy in South East Asia that contributes up to 2.3% of global economic output (Jakarta, 2012). The
relationship between stock market and various macroeconomic factors in emerging economies has been featured
in several studies; however, Indonesia despite its investment potentials has received a minimal attention in this
type of study. Theoretically, stock market is said to be influenced by some fundamental macroeconomic variables.
When trend of a stock market is known, it will be of great benefit to fund managers and potential investors in the
market who seek for an insight of the future corporate earnings and how much to expect in terms of interests and
dividend. It also helps them to understand how the market functions to implement portfolio diversification
strategies when considering investing in an emerging stock market like Indonesia. The understanding of the
interaction between stock market and major macroeconomic variables may be helpful to predict future economic
International Journal of Economic Perspectives ISSN 1307-1637 © International Economic Society
International Journal of Economic Perspectives, 2017, Volume 11, Issue 2, 665-684.

Exchange rates is one of those; currencies are often included in investment funds portfolio as an asset, therefore,
an accurate estimate of the impact of the variability in exchange rate is, therefore, needed for a given portfolio
(Dimitrova, 2005). Some policy makers' advocate for weak currency, as it is said to boost export sector, this type
of study would shed more light to policy makers and create an awareness of what policy direction they should take
to propel their economies. An economy with a positive net export benefits from depreciating currency while one
with a negative net export will prefer a stronger domestic currency. Interest rate is a tool used by the government
to give the economy a boost. It is raised to slow the economy down and attract foreign investors from stronger
economies and lowered to promote economic growth by increasing the money in circulation. Interest rate is an
important factor and investors must monitor its level and growth in various sectors of the economy to be able to
evaluate the impact on profitability and performance of firms (Osamwonyi & Osagie, 2012). Inflation is an
important factor in an economy and it is of great importance to investors. Funds tend to flow out of an economy
that is experiencing inflation; people are also less likely to hold cash during inflation due to loss in monetary value.
When inflation is not well managed in an economy, it may result in the collapse of value of stocks in the market
(Geetha et al.,, 2011).

Share prices increase because of expectation of higher profits from healthy business environment. Investors
therefore have more confidence in an economy that is striving well; therefore, a positive linkage is expected
between economic growth and stock prices (Osamwonyi & Osagie, 2012). The relationship between
macroeconomic factors such as exchange rates, interest rates, inflation and economic growth is of paramount
interest to investors, fund managers as well as economic planners. This paper, therefore, is aimed at investigating
the short and long-run relationship between the following macroeconomic variables: interest rates, inflation,
economic growth, exchange rates; and the stock market in Indonesia. The result of the findings will be useful to
these interest groups for investment and policy decisions. This investigation will lead to the achievement of the
following objectives:

- Identification of the trend and pattern of macroeconomic variables and stock market in Indonesia.

- Expression of the short and long-run relationship between macroeconomic factors and stock market using
cointegration and vector error correction model techniques.

- Presentation of the visualization and numeric impact of the shock of each macroeconomic variable on the stock
market in Indonesia using impulse response function and variance decomposition.

- Identification of which of the macroeconomic variables have the greatest impacts on the stock market.

This study is targeting to achieve those objectives in the following chapters.


Empirical evidences on the linkage between macroeconomic factors and stock market in emerging economies had
been numerous especially in this era where investors are considering investing in emerging economies due to high
growth in returns on investments. The evidences provided by various researchers had not followed a pattern.
Godfrey (2013) suggested that capital allocation variation and institutional differences within and between
countries has made findings in an emerging country not to be generalized thus, the increasing need for country
specific studies. Evidence from literature show a number of statistical methods employed such as; Vector error
correction model (VECM), Vector autoregressive model (VAR), Ordinary least square method (OLS), Granger
causality, Cointegration, Impulse response function, Variance decomposition, Box-Jenkins autoregressive
integrated moving average (ARIMA) and Generalized autoregressive conditional heteroskedasticity (GARCH).
All these methods are unique as they measure various ways in which variables can be linked together. Arbitrage
pricing theory (APT) is the theory that identifies that stock market returns are affected by various macroeconomic
factors but the theory has its shortcoming by not being able to specify these macroeconomic factors. Chen et al.,
(1986), therefore, proposed a set of relevant variables which are industrial production, inflation, risk premium,
term structure, market indices, and consumption as well as oil prices.

The impacts of these variables were tested in the New York stock exchange market and result confirmed that stock
returns are exposed to systemic economic news. However, researchers have also added and deducted from these
variables as some of the variables are not available for emerging or pre-emerging countries. Some empirical
evidences from these researchers are:
International Journal of Economic Perspectives ISSN 1307-1637 © International Economic Society
International Journal of Economic Perspectives, 2017, Volume 11, Issue 2, 665-684.

Geetha et al., (2011) examined the relationship between stock returns and inflation in Malaysia, United States and
China. Inflation was expressed using two different variables which are expected and unexpected inflation. Using
monthly data from 2000 to 2009 and employing cointegration and error correction model technique, the study
revealed a long run relationship for the three countries but no short run for Malaysia and US. Guneratne (2006)
investigated the relationship among macroeconomic variables and stock prices in Sri-Lanka, an emerging market.
Six macroeconomic variables (Consumer price index, money supply, gross domestic product, three-month fixed
deposit rate, exchange rate and US stock market index) were examined in monthly frequency ranging from 1985
to 2004. Cointegration, error correction models, variance decomposition and impulse response function were used
to analyse the data. Results showed the evidence of both short and long run relationships between macroeconomic
variables and stock prices in Sri-Lanka.

Adam and Tweneboah (2008) examined how macroeconomic variables impacts stock price movement in Ghana.
Four basic macroeconomic variables were used which are; foreign direct investment (inflow), interest rates,
consumer price index and exchange rate. Innovation accounting technique and cointegration test were used to
analyse quarterly data from 1991 to 2006 and the findings showed cointegration between stock market and
macroeconomic variables indicating a long run relationship. The results also showed that interest rates and foreign
direct investment are the key determinants of stock price movement in Ghana. Omondi and Tobias (2011)
investigated the effect of foreign exchange rate, interest rate and inflation on stock return volatility in Nairobi stock
exchange. Monthly time series data from 2001 to 2010 was analysed using exponential generalized autoregressive
conditional heteroskedasticity (EGARCH) and threshold generalised autoregressive conditional heteroskedasticity
(TGARCH). The findings showed that interest rate, inflation and exchange rate impacts stock market volatility in
Kenya. Naik and Padhi (2012) examined the relationship between India stock market index and five
macroeconomic variables (industrial production, whole sale price index, money supply, Treasury bill rates and
exchange rate).

Monthly data ranging from 1994 to 2011 was analysed using Johansen cointegration and vector error correction
model to study the short and long run equilibrium relationship between the stock market and macroeconomic
variables. Results showed a long run equilibrium relationship and positive impact of money supply and industrial
production but negative impact of inflation rates on stock market. Short term interest rate and exchange rates were
not statistically significant in determining stock prices in India. Our research employs cointegration and vector
error correction model on monthly time series data ranging from 1990 month 1 to 2014 month 12 to investigate
the possible short and long-run relationship between the following macroeconomic variables; interest rates,
inflation, economic growth, exchange rates; and the stock market in Indonesia. Other necessary statistical tests
including Impulse response function (IRF) for VECM and variance decomposition has been employed as detailed
in the methodology section. To our knowledge this research is the first study of its kind in terms of the country,
macroeconomic variables used, time horizon and the statistical method employed.


This part defines and details the techniques and procedures employed in this research; this includes data collection,
justification for choice of variables, model specifications and required analysis. The discussion of the reasoning
for the choice of the variables gives the rationale behind the selection of the four major macroeconomic variables
and their possible linkage with stock prices. This research uses quantifiable observations to represent each of the
variables so that tests can be conducted using statistical analysis. Tests undertaken and the decision rules for the
tests are outlined and clearly detailed in subsequent sections.

Data is retrieved from reliable sources and the strategy for the collection of data is archival. Data is collected
repeatedly over a long period which is a type of longitudinal time horizon. In this research, data selection is based
on studying part of a population which is known as sample. The type of sampling used in this research is the
purposive sampling because the researchers have deliberately selected the sample period. The reason being that
stock market of most developing nations started to gain international recognition in the 1990s and this allowed
foreign investors to purchase and sell securities in the market. Data are sourced for stock prices from Trading
Economics and Federal Reserve Economic Data (FRED). Data collected from these sources is for a period of 25
years (1990 - 2014) which gives a total number of 300 observations per variable. Since stock prices change daily,
it would have been ideal to use daily frequency data but most macroeconomic data are recorded on monthly,
quarterly and yearly basis. It is therefore admissible to use monthly frequency as stock prices would not have
deviated too much within the space of one month. Data used in this research is studied over time, therefore, a time
series analysis is utilised.
International Journal of Economic Perspectives ISSN 1307-1637 © International Economic Society
International Journal of Economic Perspectives, 2017, Volume 11, Issue 2, 665-684.

Choice of variables in this type of research has been a thing of concern as previous studies suggest various
macroeconomic factors; the researchers have, therefore, created a sampling table so as to be able to identify which
variables have been mostly used by researchers.

Table 1. Sampling Table

(Osamwonyi & Osagie, 2012)

(Olukayode & Atanda, 2010)

(Iskenderoglu, et al.,, 2011)

(Khan & Senhadji, 2000)

(Muazu & Musah, 2014)

(Daferighe & Aje, 2009)

(Semra & Ayhan, 2010)

(Tursoy, et al.,, 2009)

(Naik & Padhi, 2012)

(Akbar, et al.,, 2012)

(Olorunleke, 2014)
(Adaramola, 2011)
Names and Variables

(Osuagwu, 2009)
(Kadir, 2008)

(Kutty, 2010)
Industrial Production (x) (x) (x) (x)
Inflation rate (x) (x) (x) (x) (x) (x) (x) (x) (x) (x) (x)
Interest rate (x) (x) (x) (x) (x) (x) (x) (x) (x) (x) (x)
Gross Domestic Product (x) (x) (x) (x)
Money supply (x) (x) (x) (x) (x) (x) (x) (x) (x) (x) (x)
Exchange rate (x) (x) (x) (x) (x) (x) (x) (x) (x) (x)
Consumer Price Index (x) (x)
Treasury bills (x)
Risk premium (x)
Foreign reserve (x)
Fiscal deposit (x)
Note: (x) Indicate the inclusion of a variable in the study.

The table above shows names of researchers as well as the variables that were included in their studies. The most
commonly used variables based on this sampling table are inflation/consumer price index, exchange rates, interest
rates, gross domestic product/industrial production (a measure of economic growth) and money supply. This
research is set to give an equal level of measurement to all variables, therefore, the daily swift changes of stock
price had been considered and the researchers have decided to examine variables that are available on monthly
basis as quarterly or annual frequency would not capture the variations in the movement of stock prices. Gross
domestic product and inflation rates of countries like Indonesia are not available in monthly frequencies, therefore,
industrial production and consumer price indexes are used as proxies respectively for these two variables. Money
supply which is the measure of the total amount of currency in circulation is also a variable that researchers in this
field are interested in because of its impact on inflation, value of domestic currency and business cycle.

The quantity theory of money suggests that money supply hasa direct relationship with general price level. This
simply implies that an increase in money supply causes prices of goods to go up which indicates inflation in an
economy. Kryzonowski et al., (1994) warned financial economists to be careful while selecting variables to avoid
the problem of multicollinearity. To guard against this sort of problem, the researchers have avoided using money
supply as one of the macroeconomic variables; this is because, consumer price index which is selected shows the
growth or decline of money supply and the demand for money in a nation is a function of interest rate which is
also one of the variables selected. Table 2 shows the variables chosen for this research, their description and source.
A further explanation of the rationale behind the choice of these variables is given in subsequent sub section to
espouse the conceptual and theoretical underpinning.

This is the major stock market index in Indonesia and it accounts for the performance of all companies listed on
the Indonesia stock exchange. It is a modified capitalization-weighted index with a base value of 100. JCI is a
general indicator of all stocks listed on Jakarta stock exchange market. It comprises of more than 400 companies
that are listed on the stock exchange. Although JCI was influenced by the Asia financial crisis in 1997, it however,
recovered and grew more than seven times of its original level in early 2000.

International Journal of Economic Perspectives ISSN 1307-1637 © International Economic Society
International Journal of Economic Perspectives, 2017, Volume 11, Issue 2, 665-684.

JCI has experienced a stable growth just after the global meltdown in the late 2000s. A significant growth of up to
19% was experienced in 2011 with 4978 index point and has since 2012 to date have index points ranging from
4000 to 6000.

Table 2. Research Variables

Country  Variables  Description Source

Indonesia  Jakarta Composite index  The main index in Indonesia Trading
stock exchange market  economics 
  Industrial production  Measure of overall economic FRED
  Consumer price index  monthly consumer price FRED
  Indonesian rupiah/US 1 Rupiah per US dollar FRED
  Discount rate/borrowing Borrowing rate FRED

Interest rate (IR) according to Alam and Uddin (2009) is the cost of capital and they gave two definitions of interest
rate from a lender and a borrower’s point view. To a borrower, IR is the fee that is paid for using money over a
period (borrowing rate) and to a lender, IR is the amount that is charged for using money over a period (lending
rate). They examined the relationship between interest rate and stock prices and found a negative one. Interest
rates influences profits made by firms which in turn influences investor’s expectation of higher dividend payments.
The high capital requirement that is needed in setting up businesses leads to companies taking the option of debt
financing which gives them the opportunity to purchase inventories and equipment, an increase in borrowing rate,
therefore, results to higher cost of borrowing which negatively influences the future expected return of the firm.
On the other hand, a reduction in borrowing rate decreases the costs of borrowing which serve as incentives for
firms to expand and increase their profitability thus a positive effect is, thereby, expected on the firm’s output.

The consumer price index is a variable that is used as a proxy for inflation rate. It is a variable that is used to
measure the general price level of consumer goods and services that are purchased by households. It is the weighted
average of prices of a basket of consumer goods and services such as transportation, food and medicare. It is
calculated by taking price changes for each item in the predetermined basket goods and averaging them. Goods
are weighted according to their importance. The findings of Chen et al., (1986), who were the first set of researchers
to examine the relationship between inflation and stock prices, pointed towards a negative relationship between
the two variables. Inflation could have a negative as well as positive impact on stock prices based on past
researchers. Osamwonyi and Osagie (2012) mentioned that during inflation, investors undervalue stocks due to
failure in considering capital gains and that stock prices are determined using earning price ratio which tend
towards nominal interest rate rather than real interest rate. Inflation in a nation is usually an increase in price level
of commodities and this often influences purchasing power of the nation’s currency. Countries with pegged
currencies especially those with currency pegged to US dollars have a limited experience of inflation but could
suffer from speculative attacks.

Stock holders during inflation have the opportunity of holding on to their stocks when prices are going up, and at
the time they are willing to sell, investors must pay more to acquire them which enriches the pocket of stock
holders. This is the positive influence inflation can have on stock prices. On the other hand, firms’ experiences
increase in expenses during inflation which influences profitability and this extends the impact to share prices.

This is the rate at which one currency is exchanged for another. It is also the value of a country’s currency in terms
of another. Exchange rate is a product of a nation’s external trade and it is also directly related to the balance of
payments of the country. Balance of payment and external trade influences the exchange rate. Depreciation of a
nation’s currency leads to an increase in demand for the country’s export products which increases cash inflow in
the country. Firms of a nation pay attention to the variation in the currency to be able to manage foreign contracts
or importation of raw materials. Ito and Yuko (2004) explained the relationship between exchange rate and stock
prices by suggesting that the relationship between the two variables contributed to the spread of the Asia financial
crisis in 1997. The depreciation of Thai baht had a great impact on the nation and its environs and it led to stock
market crash at the time.
International Journal of Economic Perspectives ISSN 1307-1637 © International Economic Society
International Journal of Economic Perspectives, 2017, Volume 11, Issue 2, 665-684.

Alternatively, if a nation’s currency is expected to appreciate, investors will be willing to invest in such a nation
and increase in demand causes stock market returns and prices to go up. This instance suggests a positive impact
of exchange rate on stock prices. Moreover, exchange rate impact may equally depend largely on the level of trade
balance and international trade. Therefore, the impact of the variable on the Indonesia stock prices is determined
by dominance of import and export of the economy.

Industrial production is used as a proxy for economic growth. It is used to measure changes in the price-adjusted
output of industry, it also measures the real production output of industries such as mining, manufacturing and
utilities. It measures production output and highlights structural development in the economy. It is used to explore
production variation in short term period and it is used to calculate macroeconomic indicators like gross domestic
product. Industrial production (IP) is a measure of real economic activity of Indonesia studied in this research. It
measures the output of industries such as manufacturing and mining. IP is well known for its response to the state
of the economy. It rises during economic boom and declines during recessions which show its procyclical nature.
IP reflects growth in relevant industries of the economy. Firm growth is usually influenced by environmental
factors especially growth in the economy. When industries in a nation are doing well, firms generate more cash
flow as a result and there will be increase in productivity and profitability which would trigger share prices to go

The research seeks to investigate how Indonesia stock exchange market responds to changes in some set of
macroeconomic variables in the short and long run. Using statistical techniques, the following hypothesis are
therefore subjected to tests;

 Macroeconomic variables do not have significant long-run relationship with the stock market in Indonesia

 Macroeconomic variables have significant long-run relationship with the stock market in Indonesia

 Macroeconomic variables do not have significant short-run relationship with the stock market in

 Macroeconomic variables have significant short-run relationship with the stock market in Indonesia

 Inflation and interest rates have negative relationship with the stock market in Indonesia

 Inflation and interest rates have positive relationship with the stock market in Indonesia

 Exchange rates and economic growth have positive relationship with the stock market in Indonesia

 Exchange rates and economic growth have negative relationship with the stock market in Indonesia

The null and alternative hypothesis will be tested and analysed and rejection or acceptance of null or alternative
hypothesis is justified using cointegration and vector error correction model techniques. Method used in this
research begins with a process of a regression analysis and the following equation shows a representation of the
dependent and intervening variables.

LJCI = LCPI + LIP + LER + LIR + ? (1)

The equation above represents the intercept which is usually a constant and it is the expected mean value of the
dependent variable LJCI (log of Jakarta composite index) when all intervening variables LCPI (log of consumer
price index), LIP (log of industrial production index), LER (log of exchange rate) and LIR (log of interest rate) are
equal to zero, represents the sensitivity of each of the chosen macroeconomic variables in relation to stock prices
in Indonesia. (?) is the error term which stands for all other factors that influences stock prices while L indicates
that variables are in their natural logarithm form. The base t shows that variables are studied over time. To
understand the data movement, variables are plotted in a graph and a table is presented to show the results of the
sample mean, skewness, kurtosis, standard deviation, p-value and Jacque-Berra statistics. The results derived from
these are explained in the analysis section. The standard deviation results indicate the level of volatility of each of
the variables and the normal distribution of the intervening variables is tested using the skewness and Kurtosis.

International Journal of Economic Perspectives ISSN 1307-1637 © International Economic Society
International Journal of Economic Perspectives, 2017, Volume 11, Issue 2, 665-684.

Most macroeconomic variables are close substitutes, therefore, there is a tendency of correlations of high
magnitude among the intervening variables selected in this study, this has prompted the need to do a
multicollinearity test to be able to detect the correlation among intervening variables as results derived from a
model with multicollinearity problem are said to be biased.

As mentioned earlier, this test is necessary to be sure that multiple correlation of sufficient magnitude does not
exist among intervening variables as this would influence the regression estimates. Multicollinearity problem leads
to the following; non-significant result, predictor beta moving in a non-sensible direction and large standard errors.
To identify this problem, variance inflation factor (VIF) is employed on the intervening variables. VIF values of
9 or less are often the criteria to validate that intervening variables does not have multiple correlations while values
of 10 or more shows correlations among the intervening variables. This test is of great importance due to the
suggestion made by Kryzonowski et al., (1994) who emphasized on multicollinearity problem in the issue of factor
selection. There are ways to correct the problem of multicollinearity that should the researchers identify one. The
following solutions are suggested: exclude the redundant variable in the model; increase the sample size to add
more stability to the data; apply first differenced transformation technique and lastly, check if two variables are
duplicates to replace one with another variable.

The preferred way to correct multicollinearity is the third point mentioned which is to use first differenced data.
This is because Granger and Newbold (1974) recommended the use of differenced form of variable before running
regression. Since all our tests are done through the process of regression, it is the best way to correct
multicollinearity. Before this is achievable, it is ideal to check for stationarity of data which is done through the
unit root test, however, it is important to first identify the number of lag lengths that must be included in the
estimation of our model, therefore, a lag selection test is conducted.

Appropriate lag length is very important as it helps to avoid inconsistency in Vector autoregressive model. The
two ways to approach this are through information criteria restriction or cross-equation restrictions. This study
uses the information criteria restriction; the method focuses on residual sum of squares. The aim of this is to choose
appropriate number of lags that can reduce information criterion values. Lag lengths would be justified using three
tests which are; Akaike’s information criteria (AIC), Schwarz’s Information criteria and Hannan-Quinn
information criteria. All these three will be put into consideration in selecting a suitable lag length for the model.

After multicollinearity problem is checked, the research would proceed to checking for stationarity of the variables
employed. Most economic and financial time series data are not usually stationary in their level form and non-
stationary data cannot be used to estimate parameters or run cointegration tests as it could lead to arriving at
misleading results which is also known as spurious regression. Spurious result is a form of Type II error which
could be in form of high R squared, inflated t-ratios and small standard errors in the models estimated. Stationarity
in time series occur when mean and variance of the data is constant over time. In an equation like this;


Where Y is the choice variable, is the intercept, is the coefficient of the intervening variable X, is the error term
and t denotes time i.e. t = 1,2,3….n. Applying differencing operation gives results of observations such as;

X level

X (1st differenced state)

X (2nd differenced state)

There are two basic types of unit root tests that are common to researchers which are employed in this research;
they are augmented Dickey-Fuller (ADF) and Phillips-Perron unit root tests.

Augmented Dickey-Fuller (ADF) test is developed by Dickey and Fuller (1979) where they examined data using
trend and intercepts. ADF regression decide whether to include constant, trend, drift or lag lengths for the
differences that augment the regular Dickey-Fuller regression. If time series must be differenced for it to become
stationary, it is said to be integrated of order d, I (d);

I – refers to integrated and d denotes the number of times the data is differenced.
International Journal of Economic Perspectives ISSN 1307-1637 © International Economic Society
International Journal of Economic Perspectives, 2017, Volume 11, Issue 2, 665-684.

Gujarati and Porter (2009) modelled unit root and expressed time series variables as follows;

∆ ∑ ∆ (3)

Y is the choice variable, α is the intercept, ∆ is the first difference operator,

α represents i 1 and 2 ε is the stationary stochastic process, P is the number of lagged terms .

The decision rule for the ADF test statistics is based on a null and alternative hypothesis,

H :α 0 which denotes presence of unit root or non stationarity of data

H :α 0 which denotes absence of unit root or stationarity of data

The decision rule for the ADF test statistics is based on a null and alternative hypothesis. The output of the tests
gives McKinnon’s critical values and ADF value, the null hypothesis of presence of unit root is rejected when the
ADF value is higher than McKinnon’s critical value, and when McKinnon’s critical value is higher than ADF
value, we fail to reject null of hypothesis of unit root. Stationarity of time series data confirms the suitability of
the data for model estimation. ADF is a test that helps to determine whether economic time series is trend stationary
or difference stationary.

Phillips-Perron (PP) test is developed by Phillips and Perron (1988) and it differs from the ADF test, unlike the
ADF test that includes serial correlation of error term with lagged difference; PP ignores serial correlation and
replaces it with non-parametric statistical method with exclusion of lagged difference terms, this helps to correct
heteroskedasticity and serial correlation in the errors. PP takes variables in their first differenced log form to
eliminate the possibility of non-stationarity of data as financial and economic variables are likely to be stationary
in their first differenced form.

Cointegration test is the concept of Granger (1981) and was fully developed by Johansen (1988), and it is useful
in determining long run relationship among variables. Let’s assume non-stationary after first differencing I (1)
then the linear combin LIR ation


will also be non-stationary of the same order. Cointegration means that variables move in the same direction which
indicates that they share common stochastic trend. To test for cointegration in a model, stationarity test is first
performed on the error term, and this is observed using least square residuals of error term (). If the residuals are
stationary based on the test conducted, then Y and X are cointegrated. Existing literature has employed the
cointegration test developed by Johansen (1988) to investigate cointegration among variables. There are two
different forms of Johansen’s cointegration tests which are bivariate and multivariate cointegration tests. The
bivariate test is useful when the relationship between stock prices and a macroeconomic variable is examined while
multivariate cointegration test considers the relationship between all macroeconomic variables selected as one
entity on the dependent variable which is stock prices. Johansen test therefore assumes a null hypothesis of no
cointegration among variables at 5% level of significance. In examining this, trace and maximum Eigen statistics
methods are applied. The equations for these tests are as follows;

∑ ln 1 (5)

, 1 ln 1 (6)

in Equation (5) is the ordered Eigen values, r is the cointegrating vectors and n is the number of variables. The
output of the results derived is reported under analysis section using a table which specifies the values for (r=0, 1,
2, 3...n-1). The null and alternative hypothesis is as follows;

: 0

: 0

International Journal of Economic Perspectives ISSN 1307-1637 © International Economic Society
International Journal of Economic Perspectives, 2017, Volume 11, Issue 2, 665-684.

When trace value is greater than the critical value in absolute terms then one should reject the null hypothesis of
no cointegration and when trace value is less than critical value, then you fail to reject the null hypothesis of no
cointegration which indicate no long run relationships among the variables. Equation (6) is the formula
representing the maximum Eigen method of cointegration. It assumes a given r under the null hypothesis against
the alternative of r+1 cointegrating equations. The hypothesis for the maximum Eigen test is;

1 1,2,3 …

This test considers critical values at 5% level of significance when making decisions. When maximum statistics is
greater than critical value, then null hypothesis is rejected and when maximum statistics is less than critical value
in absolute terms, then you fail to reject null hypothesis.

After the cointegration test is performed, the VECM model is a restricted vector autoregressive (VAR) where the
dependent variable is not covariance stationary in its level form but in first difference form. According to Granger’s
representation theorem, VECM is just a representation of cointegrated VAR. The VECM helps to investigate the
short run relationship amongst the variables. Short run dynamics are measured by the speed it takes the dependent
variable to deviate and go back to its point of equilibrium. The VECM explains the time it takes the dependent
variable to change because of influences from intervening variables. The VECM structure is specified as the
equation below;

∆ ∆ (7)

ECT in the equation above is the value attached to the speed at which deviations from equilibrium is corrected.
The error correction term in the equation for all X variables (intervening variables) would help to determine the
short run effect of intervening variables on the dependent variable. The advantages of the VECM are; the resulting
VAR from VECM representation has more efficient coefficient estimate, it restricts the long-run behaviour of the
endogenous variables to converge to their cointegrating relationship while allowing a wide range of short run
dynamics and VECM makes the concept of cointegrationuseful for modelling and inference for macroeconomic
time series.

Impulse Response Function (IRF) is a tool used for interpreting vector autoregressive model (VAR). It is used to
measure the reaction of variables to shocks emanating from another variable. It shows the vanishing rate, size and
magnitude of the effect of shocks. IRF from stationary VAR model is said to die out over time while IRF from
VECM does not usually die out over time. This is because stationary VAR model is time-variant variance which
makes it possible for the effect of shocks to die out to enable variables go back to its mean. Moreover, variables
that are stationary in their differenced form in VECM are not mean-reverting which supports the assumption of
the effect of shocks not being able to die out over time. The terminology given to shocks that dies over time is
transitory shocks while a shock that does not die out over time is referred to as permanent shocks. The result of
test would be presented in a graph and the interpretation of the graphs is given based on the guidelines stipulated.
The variance decomposition shows the proportion of the forecast error of a variable due to another variable. It
helps to determine the importance of each intervening variable in creating fluctuations in the dependent variable
(Ratanapakorn & Sharma, 2007).


The output of each of the tests conducted is presented was obtained by Eviews 7.1, a statistical software that is
used in finance and economics.

Descriptive statistics is a way of quantitatively explaining the patterns and trends of dataset and giving a summary
of the data in numerical value. Table 3 presents the summary of all the variables that is used in this study. Using
300 observations, first we examined the measure of variability exhibited by each of the variables, variability
indicates how spread out the data is and the standard deviation provides an index of variability in the distribution.
The negative skewness observed in ER indicates that ER data falls close to the tail on the left of the probability
density in a bell-shaped curve while the positive skewness observed in JCI, IR, IP and CPI indicates that the data
of these variables fall to the right side of the curve. IP and CPI exhibit nearly normal distribution which is in line
with the suggestion of the measure of central tendency (mean and median).
International Journal of Economic Perspectives ISSN 1307-1637 © International Economic Society
International Journal of Economic Perspectives, 2017, Volume 11, Issue 2, 665-684.

Table 3. Results of Descriptive Statistics

Variables CPI ER IP IR JCI

Mean 58.25158 7145.332 84.26891 13.07043 1467.213
Median 54.71642 8925.500 84.33125 11.04500 617.2750
Maximum 130.7391 13962.50 127.5327 70.81000 5226.940
Minimum 12.08572 1804.850 47.45341 5.750000 226.6840
Std. Dev. 36.21316 3542.771 17.44668 9.663603 1468.135
Skewness 0.284526 -0.527032 0.087921 3.681830 1.228532
Kurtosis 1.733584 1.687354 2.674528 19.26104 3.081037

Jarque-Berra 24.09537 35.42609 1.710657 3983.061 75.54663

Probability 0.000006 0.000000 0.425143 0.000000 0.000000

Sum 17475.47 2143600. 25280.67 3921.130 440163.9

Sum Sq. Dev. 392106.4 3.75E+09 91011.56 27922.18 6.44E+08

Observations 300 300 300 300 300

CPI- Consumer price index, ER- Exchange rate, IP- Industrial production, IR- Interest rate, JCI-Jakarta composite index

When mean is greater than median, there is a positive skewness in place and when mean is less than median, there
is a negative skewness in place. The maximum and minimum gives the range of the data and a small range suggests
that data are close together but if they are large, it means data is more spread out.The mean of JCI is 1467.2 while
the maximum price is 5226.9. The standard deviation is 1468.1 which indicates a very high variability in Jakarta
composite index. IP exhibits moderate variability with a mean of 84.27 and standard deviation of 17.44. For a
standard deviation that is almost half of the value of the mean like the case of CPI and ER, there is a possibility
that variables have high but moderate variability. Table 4 is presenting the results of Multicollinearity Test.

Table 4. Variance Inflation Factor (VIF) Output

Variables  VIF  1/VIF 

CPI  10.13  0.0987 
IP  5.1  0.1962 
ER  4.1  0.227 
IR  1.75  0.5728 
Mean VIF  5.34   
VIF- Variance Inflation Factor

The VIF is a quantifiable measure of how much the variance is inflated in the model we are about to estimate. The
variance in this concept means standard errors. To calculate VIF, Where represents the proportion of the
variance of independent variable i that is related with the other independent variable in the model estimated. VIF
measures how much variance of the estimated regression coefficient is inflated as compared to when the predictor
variables are not linearly related. VIF of 5.3 implies that the standard errors are larger by a factor of 5.3 than would
otherwise be the case. A value of 10 according to Hair et al., (1995) and Kennedy (1992) is recommended as the
maximum level accepted. Therefore, our set of variables is clear of multicollinearity problem.

All variables are taken in natural logarithm form and presented in Figure 1. Stationarity in series enhances the
reliability and accuracy of model estimated and it helps the researchers to draw a meaningful inference in a time
series analysis. Non- stationarity data often leads to biased or spurious result in analysis. Pattern and trend are the
common characteristics of a non-stationary data and can be visualised in a graphical representation of data. The
five series plotted in Figure 1 exhibit various patterns and trends. LJCI, LIP and LCPI are seen to exhibit upward
trend and are also noticed to be wandering or better still fluctuating around a trend while LIR is fluctuating around
a constant. LER seems to be wandering around a constant and a trend. In all, all variables exhibit a sign of non-
stationarity graphically but this cannot be limited to a mere visual inspection. Therefore, a formal test for
stationarity is suggested so as to have a concrete conclusion of whether variables are stationary or not.

International Journal of Economic Perspectives ISSN 1307-1637 © International Economic Society
International Journal of Economic Perspectives, 2017, Volume 11, Issue 2, 665-684.

Figure 1.
Graphical Illustration of Each of the Variables

The table below shows the number of lag lengths suggested by AIC, SC, HQ and FPE.

Table 5. Lag-Length Selection


0 2.88e-06 1.431409 1.493746 1.456367
1 3.53e-14 -16.78655 -16.41253 -16.63680
2 1.36e-14 -17.74271 -17.05700* -17.46816
3 1.18e-14* -17.88473* -16.88734 -17.48540*

Final prediction error (FPE), AIC and HQ criteria suggest maximum of 3 lags while Schwarz’s information criteria
suggest maximum of 2 lags. This model will stick to 3 lags as suggested by 3 different information criteria for
model estimation.

Table 6. ADF and PP Results

Augmented Dickey Phillips-Perron Test

Fuller Test statistics statistics
(H0: Unit root /Non- (H0: Unit root/Non-
stationary) stationary)
Variables Level First Difference Level First Difference
LJCI -0.1344 -12.0259* -0.0838 -13.8608*
LIP -1.4912 -10.4805* -2.0217 -37.479*
LER -1.445 -5.7891* -1.3969 -13.1669*
LCPI -1.0925 -4.3296* -1.35 -8.4141*
LIR -2.2717 -6.5114* -1.9527 -9.6047*
Test critical
5% Critical -2.8712
10% critical -2.572
* indicates that variables are significant at 5% critical level
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International Journal of Economic Perspectives, 2017, Volume 11, Issue 2, 665-684.

Table 6 shows the variables in level as well as the first difference state. All variables exhibit non-stationarity in
level but stationary after first differencing. This implies that variables are integrated of Order I (1). The null
hypothesis of unit root is accepted for all variables in level form but rejected for all variables in first difference
form which indicates that variables are stationary after first differencing. In order to be accurate in unit root testing,
Phillips-Perron unit root test is also employed to confirm the stationarity of variables. The table shows the ADF
and PP values of each of the variables and shows the McKinnon’s critical value at the tail end of the table. The
null hypothesis of presence of unit root is rejected when ADF or PP value is greater than McKinnon’s critical

The ADF and PP values are less than critical values in level form indicate that all variables are non-stationary
while the first difference shows that ADF and PP values are greater than both 5% and 10% critical values which
suggest the rejection of the null hypothesis of presence of unit root. Both tests show that variables are not integrated
of Order I (0) but of Order I (1). All variables are therefore difference stationary of the same order. The finding is
not uncommon (Nadeem & Zakir, 2009). The first difference data can be visualized in the illustration below:

Figure 2.
First Difference State Graphical Representation

It can be seen that all variables do not exhibit upward or downward trend but are stationary over time. The
stationarity of all variables in same Order I(1), therefore leads to Johansen multivariate cointegration test. This
helps to examine the long –run impact of ER,IP,IR,CPI and JCI.

Using lag length 3, the Johansen cointegration test results output for trace and maximum Eigen statistics. Trace
and maximum statistics are reported in tables 7 and 8 respectively. Table 7 indicates that for none (0) and at most
1 cointegrating equations, trace statistic value is greater than 0.05 critical value while for at most 2 cointegrating
equations, trace statistic (22.8977) is less than 0.05 critical value (29.797) which from all indication suggests that
we do not reject null hypothesis of at most 2 cointegrating equation in the model.

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International Journal of Economic Perspectives, 2017, Volume 11, Issue 2, 665-684.

Table 7. Unrestricted Cointegration Rank Test (Trace Statistics) Result

Hypothesized Trace 0.05

No. of CE(s) Eigen-value Statistic Critical Value Prob.**
None * 0.121781 90.69698 69.81889 0.0005
At most 1 * 0.095134 52.38848 47.85613 0.0177
At most 2 0.047209 22.89776 29.79707 0.2511
At most 3 0.020545 8.631781 15.49471 0.4005
At most 4 0.008465 2.507793 3.841466 0.1133
*Indicate rejection of null hypothesis at 5% significant level

The Maximum Eigen statistic helps to confirm the trace statistic result. Using the same guideline with trace statistic
method, the maximum Eigen statistic (Table 8) is greater than 0.05 critical values when we have null hypothesis
of none (0) and at most 1 while maximum Eigen value (14.266) is less than 0.05 critical value (21.13) which
suggests that we should fail to reject the null hypothesis of at most 2 cointegrating equations. Both trace and
maximum Eigen statistic suggest that the model has at most 2 cointegrating vectors therefore, the study proceeds
to using 2 cointegrating equations to establish the long-run equilibrium relationships among the variables in the

Table 8. Unrestricted Cointegration Rank (Maximum Eigen Value) Result

Hypothesized Max-Eigen 0.05

No. of CE(s) Eigen-value Statistic Critical Value Prob.**
None * 0.121781 38.30850 33.87687 0.0138
At most 1 * 0.095134 29.49072 27.58434 0.0281
At most 2 0.047209 14.26598 21.13162 0.3436
At most 3 0.020545 6.123988 14.26460 0.5973
At most 4 0.008465 2.507793 3.841466 0.1133
*indicates rejection of null hypothesis at 5% significant level

Johansen cointegration test indicates at most 2 cointegrating equating relations which show the existence of a long-
run relationship between the selected macroeconomic variables and stock prices. The long run output equation is
expressed below;

, , , , (8)

4.593 0.989 3.055 1.998 (9)

The equation above indicates a significant negative long-run relationship between LJCI, LCPI and LIR; and a
positive long-run relationship between LJCI, LIP and LER. This implies that one percent increase in interest rate
would result in approximately 2.0% fall in Jakarta composite index. This is in line with the suggestion of Huang
et al., (1996) that interest rate is used to discount future cash flows which eventually influences share prices and
concludes that increase in interest rate leads to decrease in stock prices. The result is also conversant with Naik
and Padhi (2012). In the long run, the result also suggests that a one percent increase in consumer price index
reduces stock prices by 4.59%. Consumer price index (a measure of inflation) having negative relationship with
Jakarta stock prices shows that the market does not provide hedge against inflation. This also indicates that
Indonesia currency is not pegged as countries with pegged currency experience limited impact of inflation. A
negative long-run relationship was also found between inflation and stock prices.

A one percent increase in exchange rate (depreciation of rupiah) results in 3.06% increase in stock prices. The
reaction of stock price movement to exchange rate depends solely on level of trade balance i.e. the difference
between export and import in the nation. A positive impact therefore suggests that depreciation of Indonesia rupiah
would lead to increasing demand for country’s production. It means Jakarta composite has more export-oriented
firms, therefore, a positive impact is expected to reflect on firm’s cash flow which leads to increase in return and
ultimately resulting in increase in share prices. In Nigeria, a negative relationship runs from exchange rate to stock
price. The obvious reason is that, the country is import dependent unlike Indonesia. A one percent increase in
industrial production results in 0.99% increase in stock prices in the long-run.

International Journal of Economic Perspectives ISSN 1307-1637 © International Economic Society
International Journal of Economic Perspectives, 2017, Volume 11, Issue 2, 665-684.

This implies that when industries in Indonesia are doing well, firms generate more cash flow which increases
productivity and profitability and causes hike in stock prices. This finding is common in the literature (Naik &
Padhi, 2012).

Table 9. Normalized Cointegration Coefficients

LJCI (-1) LIR(-1) LIP(-1) LER (-1) LCPI (-1)

1.000000 0.000000 1.778 2.870 -4.014
[2.654] [9.669] [-10.584]
t- Statistics are in parenthesis []

Results from Table 9 are just slightly different from the long run equation stated in Equation (1). The result shows
that industrial production index and exchange rate positively impacts stock prices while consumer price index on
the other hand has a negative impact.

Table 10. VECM Estimation for D (LJCI)


1 0.224* -0.072 0.121 0.141 -0.647 -0.0291***
[3.73] [-0.87] [1.84] [1.49] [-1.12] [-1.829]
2 -0.077 0.189 -0.030 0.111 0.302
[-1.19] [-0.189] [-0.25] [1.12] [0.49]
3 0.042 -0.094 0.083 -0.087 0.570
[0.661] [-1.23] [0.84] [-0.92] [1.028]
*, **, *** denotes at 1%, 5% and 10% significant level respectively. T-statistics in []

The VECM result presented in Table 10 above shows that about 11.53% of the variation in the first difference of
LJCI, i.e. D (LJCI) is explained by variations in the selected macroeconomic variables. The result also suggests
that lag difference of interest rate, industrial production index, exchange rate and consumer price index have no
significant impact on D (JCI) in the short-run. Our result reveals that, in the short run, only the first lag difference
of LJCI has a positive and significant impact on its first difference. The error correction term result is negative and
significant at 10% level. The result suggests that about 2.9% of the previous period’s disequilibrium in Jakarta
stock prices is corrected every month. The implication of this is that following a shock to the stock market in the
short-run, stock prices adjusts by 2.9% in one month to the long-run equilibrium. The result also shows that it will
take approximately (1/0.0291=34.36) 34 months to eliminate the disequilibrium in JCI before it returns fully to its
long-run equilibrium.

Cointegration and vector error correction model has shown the long-run relationship between Jakarta composite
index and selected macroeconomic variables where deviation from a systemic shock in the short-run is corrected.
However, the VECM and cointegration analysis does not specify whether the shock is from LJCI, LIR, LIP, LER
or LCPI. It is therefore important to employ the impulse response function and variance decomposition so as to
analyse and identify the various shocks. The impulse response function shows the response of JCI to shocks in
each macroeconomic variable while the variance decomposition shows the proportion of JCI which is due to
shocks from macroeconomic variables as well as its own. Although there are different types of impulse response
function, the generalized impulse is employed in this study because it is independent on ordering of the variables.
Figure 3 and Table 11 show impulse response and variance decomposition of LJCI:

The graph above shows that, a shock in interest rate results in an immediate negative or downward impact on stock
prices after first month. Although the impact does not deepen, it lingers for 12 months and probably beyond. The
response of stock prices to a shock in industrial production is positive but very close to 0. After the first 3 months,
it dies off but picks up again and dies off before the 10th month. The behaviour of stock prices to exchange rate
and consumer price index is mixed. It varies in the first 3 months, positive to a shock from exchange rate and
negative to a shock form consumer price index. However, the behaviour changes after the first quarter to negative
and positive response to shocks from exchange rate and consumer price index respectively.

International Journal of Economic Perspectives ISSN 1307-1637 © International Economic Society
International Journal of Economic Perspectives, 2017, Volume 11, Issue 2, 665-684.

Figure 3.
Impulse Response Function Graphs

Results from Table 11 reveals that changes in stock prices are driven majorly by its own variation in the first period
where it accounts for 100% of its variation and by the end of 30th and 35th period, about 79.23% and 78.87% are
respectively accounted for by its own variation. By the end of 10th month, LIR and LIP accounts for less than 1%
of the variation in LJCI while LER and LCPI accounts for 4.35% and 1.95% respectively.

Table 11. Variance Decomposition (VDC)


1 0.08 100.00 0.00 0.00 0.00 0.00
5 0.20 98.64 0.43 0.06 0.65 0.22
10 0.29 93.08 0.60 0.05 4.31 1.95
15 0.35 86.88 0.45 0.12 7.41 5.12
20 0.41 82.62 0.34 0.19 8.91 7.94
25 0.45 80.29 0.30 0.25 9.35 9.80
30 0.50 79.23 0.31 0.28 9.29 10.88
35 0.54 78.87 0.32 0.31 9.04 11.46
Cholesky Ordering: LJCI LIR LIP LER LCPI. (S.E-Standard error)

In the 35Th period, LIR and LIP does not jointly account for up to 1% variation in LJCI but LER and LCPI
accounts for 9.04% and 11.46% respectively. Another observation of the results shows that the proportion of the
variation in Jakarta composite index explained by the LER and LCPI macroeconomic variables jointly increases
in subsequent periods, ranging from 0.87% in period 5 to 12.53% in period 15, 19.15% in period 25 and 20.5% in
period 35. From period 25 onwards, it should be noted consumer price index has a slightly higher impact on LJCI
than LER whereas before these periods the reverse was the case. It should also be noted that jointly interest rate
and industrial production accounts for a very small proportion of variation in Jakarta composite index with less
than 1% in each period.


This study has investigated the short and long-run relationship between four macroeconomic factors namely;
interest rates, inflation, economic growth, exchange rates and Indonesia stock market from January 1990 to
December 2014 for Indonesia.

International Journal of Economic Perspectives ISSN 1307-1637 © International Economic Society
International Journal of Economic Perspectives, 2017, Volume 11, Issue 2, 665-684.

The macroeconomic time series data employed included monthly observations of the Jakarta composite index,
indices of industrial production, interest rate, exchange rate and inflation. The finding in the study has established
that there exists a relationship between the selected macroeconomic variables and Jakarta composite index. The
multicollinearity test indicated that the chosen macroeconomic variables does not have magnitude correlation,
therefore the model estimation in this study is reliable. All variables are not stationary in level form but stationary
after first difference conversion according to the ADF and PP unit root tests. This is represented visually in Figures
1 and 2 respectively. The Johansen test under trace and maximum Eigen statistics suggested a long-run relationship
between Jakarta composite index and the macroeconomic variables.

The long-run estimation showed a negative long-run relationship between variables such as interest rate and
consumer price index and Jakarta composite index, however, a positive relationship has been found between
variables like exchange rate and industrial production and Jakarta composite index. A negative impact of inflation
means that when demand for firm’s produce is high and inflation rises, net income and firm’s sales declines and
thus its stock price. Inflation in the economy also puts pressure on the cost of raw materials for firms, which
increases expenses and decreases cash inflow, thus putting a downward pressure on firm’s share prices. Interest
rate exhibits a negative and significant impact on stock prices; this shows that increase in cost of borrowing
(especially companies with high debt ratio) reduces net income which eventually causes decline in share prices.

These findings corroborated the results of Abduh and Surur (2013) and Oktavia (2007) where they found negative
significant impact of consumer price index and interest rates on Jakarta composite index respectively. A positive
impact of industrial production on stock price means that a stable economy encourages investors as most investors
prefer to invest in a business environment that is conducive. Building of investor’s confidence is very important
as factors like political instability, terrorism and social unrest pushes investors out of the market. Exchange rate
according to the finding impacts stock prices positively. It is not surprising since Indonesia is an export oriented
country; also 60% of the free-floating shares are owned by foreign investors. This means that depreciation in rupiah
helps to boost the export sector and this eventually increases share prices in the stock market. A similar occurrence
happened in the US between November 2003 and February 2004. Stock market in the US moved in an upward
direction at the time the US dollar depreciates against major currency (Dimitrova, 2005).

The findings are conversant with that of Oktavia (2007) where exchange rate showed a positive significant impact
on Jakarta composite index but differed from Abduh and Surur (2013) where exchange rate negatively influences
Jakarta composite index. In the short-run, interest rate and inflation also show a negative relationship while
economic growth and exchange rate show positive relationship. However, the short-run estimation for all
macroeconomic variables are not significant at 1%, 5% and 10% level of significance therefore, we can ascertain
that there is no short-run relationship between stock market and macroeconomic variables tested. Therefore, this
study can, reject the first null hypothesis which states that macroeconomic variables do not have significant long-
run relationship with stock market in Indonesia and accept the alternative hypothesis that macroeconomic variables
have significant long-run relationship with stock market in Indonesia. This study fail to reject the second null
hypothesis that macroeconomic variables do not have significant short-run relationship with stock market in
Indonesia. We also fail to reject the third null hypothesis that interest rate and inflation have negative relationship
with stock market in Indonesia.

For the forth hypothesis, the null hypothesis that exchange rate and industrial production have positive relationship
with stock market in Indonesia fail to reject. Our investigation of whether one standard deviation shock given to
each macroeconomic variable generates any response from stock prices in the short horizon using impulse response
function is interesting. This study also found that stock prices respond largely positively to its own shock and stock
prices underwent a certain degree of volatility in shorter horizons except for shocks given to interest rate which
stock prices responded to negatively and a positive but near 0 responses to shock given to industrial production.
The variance decomposition shows that exchange rate and consumer price index are the leading macroeconomic
variables that influence stock prices.

The implication of this finding is that investors can devise methods to predict stock prices in Indonesia from
macroeconomic factors. It is significant for policy makers as it would help them improve market efficiency in the
market thereby making the market more attractive to existing and potential investors. The result showed that
information about exchange rate, inflation, interest rate and economic growth can be utilized to forecast stock
market movement in Indonesia. Since inflation and exchange rates are the two leading variables that influence
stock market, successful stabilization of inflation rate in Indonesia would help reduce mispricing of assets by
investors who are subject to inflation illusion; this would contribute immensely to the efficiency of the market.
International Journal of Economic Perspectives ISSN 1307-1637 © International Economic Society
International Journal of Economic Perspectives, 2017, Volume 11, Issue 2, 665-684.

To policy makers, advocating for currency depreciation can be an option when the country wants to correct the
balance of payment. This study has shown that such policy would not depress the stock market.


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