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This study explores the long-term dynamic relationship between equity prices and monetary variables for the period June 1998 to June 2008. Monetary variables include money supply, treasury bill rates, foreign exchange rates, and the consumer price index. The data have been examined using multivariate cointegration analysis and Granger causality analysis. Johansen and Juselius’ multivariate cointegration analysis indicates the presence of a long-term dynamic relationship between the equity market and monetary variables. Unidirectional Granger causality is found between monetary variables and the equity market. In the case of money supply, a positive relationship supports the liquidity hypothesis. Impulse response analysis indicates that the interest rate shock has a negative impact on equity returns in the Pakistani equity market. Exchange rates also have a negative impact on equity returns in the short run. However inflation has little impact on returns in the equity market. Variance decomposition analysis suggests that the interest rate, exchange rate, and money supply shocks are a substantial source of volatility for equity returns. The contribution of a monetary shock to the equity returns ranges from 4% to 16% over differenttime lags. Similarly, the VECM also confirms the presence of a short-term relationship between monetary variables and equity returns. This state of affairs demands that monetary variables be considered an important factor in determining stock market movements. Policymakers should be morevigilant and careful in designing monetary policies as it has a direct impact on cash inflows into the capital market and on the stability of the capital market.

An Empirical Investigation of the Causal Relationship among Monetary Variables and Equity Market Returns