Causal Nexus Real Effective Exchange Rate, External Debt, Liquidity and Stock Value: Case study on Canada: Vector Error Correction Model (VECM) Approach

Abstract

Canada has currently one of the largest economies in the world. However, the Economy of Canada has witnessed various boom and bust over the last several decades. Real GDP growth has recorded on upward trend growth from 1980’s until 2007. However, in the aftermath of the Global financial crisis, the GDP growth rate of Canada has fallen to just below 2 percent. During the same time period, the level of Canada’s external debt, real effective exchange rate and money supply has grown exponentially. Likewise, the expansion of capital market in Canada reinforced the robust economic expansion and caused upsurge in the level of stock traded. This research examines the causal relationship between real effective exchange rate, external debt, liquidity and stock value in Canada between 1980 until 2016. To check the stationarity of the data, the research conducted Augmented Dickey-Fuller unit roots test. The result shows that after taking their first difference all variables turned to become stationary. Based on Johansen tests for co-integration, the study variables are co-integrated in the long run, therefore the research used Vector Error Correction Model (VECM). Furthermore, to verify the suitability of the data, the research conducted diagnostic tests like normality test, la-grange multiplier test and Heteroskedasticity Test. The estimation rest shows that there is both long run and short run causality among the research variables. In the short run, Canada’s liquidity has short run causality on Real effective exchange rate and Stock values. Conversely, real effective exchange rate and Government Debt have short run causal effect on Canada’s liquidity level. Likewise, stock value traded and real effective exchange rate have short run casual effect on Canada’s government debt. In the long run, the VECM estimation revealed that there is a long run causal relationship running from liquidity, government debt and stock value towards the Canada’s Real effective exchange rate (REER).