Conclusions
This paper examines the relationship between EPU and stock market liquidity over the period Januray-2003 to December-2016 in a pure order-driven emerging stock market India. In order to examine the relationship between EPU and aggregate market liquidity we employ a multivariate VAR model; carry out VAR-Granger causality tests, impulse response analysis, and variance decomposition analysis. The Granger-causality test suggests that EPU Granger-causes stock market liquidity. However, the effect of EPU is more prominent during the times of financial crisis. Impulse response analysis suggests that an innovation in EPU negatively affect stock market liquidity and strengthen illiquidity of stock market. Variance decomposition reveals a higher percentage of liquidity is attributed to monetary policy and inflation rate during normal market condition. In times of financial market crisis, EPU and investor sentiment are better predictor of stock market liquidity over monetary policy and inflation rate. Therefore, EPU may be considered as a possible source of commonality in liquidity and helpful to understand the liquidity dynamics of the stock market. Our empirical results are relevant for practitioners and policy makers. Market participants in the equity market may increase their liquidity forecast by considering EPU as an important information variable along with other macroeconomic and firm-specific variables. Regulators and policymakers may consider the relationship between stock market liquidity and EPU to reduce unnecessary uncertainties in the market, which can be useful to maintain financial market stability. Also, the information about the current economic policy uncertainty may be helpful for practitioners to gauge and assess the future stock market performance.
