Analysis of the Relationship between Business Cycles and Financial Market Indices in Iran Using an Error Correction Model

The main objective of this paper is to identify the factors affecting the business cycle in Iran through analyzing financial market indicators including, money supply, loans and deposits of banks (from the money market), and the stock price index (from the capital market).

First, using Hodrick Prescott filter, we extract the business cycles. Then, Markov Switching model estimates the optimal interrupt, and then revealed facts regarding the business cycle, including the momentum indicators, their relative variability, and their stability throughout the cycles between the variables of the financial market are compared. We used the Johansson coincidence test to recognize co integration. Finally, the model estimation is performed using Vector Error Correction Model (VECM).

The evaluated indices, regarding various facts about business cycles, show that money supply and loans are the two variables that can result in the mentioned cycles. The Johansen test and the Wald test respectively confirm the relation between the variables in both the long-term and short-term. Meanwhile, the variance analysis table shows that money supply and loans, each respectively cause, 13% and 9% of business cycles' fluctuations.

The results show that the stock market does not affect business cycles and its fluctuations. Meanwhile, the estimated error correction term in the model for the money market and business cycle variables is -0.55. This shows that every year 55% of imbalances present in the aforementioned relations are corrected in the following year. Hence, the equilibrium quickly moves towards a long-term equilibrium.