CAUSALITY TESTS OF THE REAL STOCK RETURN‐REAL ACTIVITY HYPOTHESIS

Abstract

Abstract Recent studies of the relation between real stock returns and real activity do not examine cause and effect. In this study I use Granger causality tests to examine such a relation. Results support three possibilities. First, changes in stock returns are synonymous with changes in wealth, which influence future demand for consumption and investment goods. Second, an increase in current real activity increases demands on existing capital stock, which ultimately induces future increased capital investment. The stock market anticipates these events. Third, stock returns Granger‐cause a leading economic indicator, the interest rate spread between commercial paper and Treasury bills.