Abstract

This paper strives to investigate the long-run relationship and the short-run dynamics among macroeconomic fundamentals and the stock returns of Germany and the United Kingdom. Each case was examine individually, by applying Johansen co-integration, error correction model, variance decomposition and impulse response functions, in a system incorporating the variables such as consumer price index (CPI), interest rates, exchange rates, money supply and industrial productions between the periods February 1999 to January 2011. The Johansen co-integration tests indicate that the UK and German stock returns and chosen five macroeconomic variables are co-integrated. The findings also indicate that there are both short and long run causal relationships between stock prices and macroeconomic variables. The results imply the existence of short-term adjustments and long-term dynamics for both the UK and the German stock markets returns and the certain macroeconomic fundamentals. The results of the study also indicate that the variables employed in the VARs explain some of the variation of the stock market indices, while the intensity and the magnitude of the responses are comparable for the US and the German stock markets.