An Empirical Analysis of the Impact of Fiscal Policy on Stock and Bond Markets in Sri Lanka

Abstract

Introduction:

The world’s financial market transactions have increased with a busy and modern life style. In particular, the stock market and the bond market play a key role in establishing a correlation between financial market transactions. Therefore, more and more investors have shown their interest in stock and bond market activities. When focusing on the behaviour of the above markets, deep understanding of the volatility or fluctuations of the markets is important. These markets response to changes in key macro variables, such as inflation, interest rate, monetary policy, money supply and Foreign Direct Investment, etc. Yet, there is no clear understanding of which factors cause the stock and bond markets to actually fluctuate. Some studies give priority to monetary rather than fiscal policy. Some early studies identified fiscal policy as a neglected factor (Sprinkel, 1964), and subsequent studies show that fiscal policy also has a significant impact on stock market volatility (Lapodis, 2009).

In particular, using a theoretical framework, Tobin has explained how monetary policy as well as fiscal policy influence stock market volatility. He states that the growth of money supply and budget deficits create impacts on the stock market ^Tobin, 1960&. Some empirical evidence shows that the bond market clashes with public sector debt. Government expenditure shocks are expected to be positive for stock and bond yields (Tavares and Valkanow, 2001). They found that fiscal policy generates some impacts on the volatility of both stock and bond markets. Many previous studies have identified that monetary policy has a direct relationship, and fiscal policy an indirect relationship with capital markets. Given this background, it is clear that only a few studies have focused on investigating the impact of fiscal policy on the stock market and the bond market; thus opening up an avenue to further examine the possible impacts of fiscal policy on capital market behavior.