International Business Research; Vol. 5, No. 12; 2012 ISSN 1913-9004 E-ISSN 1913-9012 Published by Canadian Center of Science and Education 59 Examining the Role of Fiscal Policy in Malaysian Stock Market Hussain Ali Bekhet 1 & Nor Salwati bt Othman 2 1 Graduate Business School, College of Graduate Studies, Universiti Tenaga Nasional (UNITEN), Kajang, Selangor, Malaysia 2 Department of Finance & Economics, College of Business and Accounting, Universiti Tenaga Nasional (UNITEN), Kajang, Selangor, Malaysia Correspondence: Hussain Ali Bekhet, Graduate Business School, College of Graduate Studies, Universiti Tenaga Nasional (UNITEN), 43000, Selangor, Malaysia. E-mail: profhussain@uniten.edu.my Received: September 26, 2012 Accepted: October 20, 2012 Online Published: November 7, 2012 doi:10.5539/ibr.v5n12p59 URL: http://dx.doi.org/10.5539/ibr.v5n12p59 Abstract This paper analyzes the relationship between stock index and macroeconomic policies (fiscal and monetary) using quarterly data for Malaysia for 1999:Q1–2011:Q4. The change in stock index was used as a proxy for financial performance. The co-integration test utilizes to detect the existence of long run relationship between stock index and macroeconomic variables and develops a vector error correction model (VECM) to test the existence of short run relationship (elasticities) among the variables. The findings indicate that there exists long run relationship among stock index, fiscal and monetary tools. This indicates that fiscal and monetary tools play an important role in accelerating financial performance in Malaysia. However, monetary tools can work faster than fiscal tools. This result would give a signal to investors to strategize their investment decision in the short and long run. Keywords: fiscal policy, financial market, stock market, co-integration, causality, Malaysia 1. Introduction The relationship between stock price and macroeconomics variables has been the subject of extensive theoretical and empirical research over the past three decades. However, large numbers of studies have focused on analyzing the macroeconomics effects of monetary variables (interest rate and money supply) and production variables (GDP, industrial production, domestic export and trade balance) [refer to Table 1]. Only a few papers discuss the empirical link between fiscal policy and stock market. In the case of developed countries, there are several studies that investigated the relationship between stock market and fiscal policy such as those of Afonso et al. (2011), Laopodis (2009), and Arin et al. (2009). Even though Afonso et al. (2011) revealed that spending and government revenue have an important effect on asset market in UK; this does not represent a developing country like Malaysia. The finding could be contradicting or vice versa. To the best of our knowledge, there are no studies related to Malaysia stock market and fiscal policy variables. This strengthens the importance of the current study and the value it adds to existing literature. Moreover, there is still a question on whether fiscal policy plays an important role in Malaysia stock market, and on which policy gives the big impact to Malaysia stock market; is it fiscal or monetary policy? Therefore, in this paper we will analyze the dynamic relationship between stock index and fiscal policy. Monetary variables will also be employed in order to compare the level of sensitivity of Malaysia stock market towards the changes in fiscal and monetary variables. Additionally, this study attempts to evaluate in terms of sensitivity of Malaysia stock market towards the implementation of fiscal and monetary policy and secondly, to investigate the co-integration relationship among stock index, monetary, and fiscal variables. For policy implications, the finding(s) of this study would help the policy makers or regulatory bodies understand the behavior of the stock market and benefit the information toward achieving monetary goals. The current study will also help investors to proactively strategize their investment decision. Furthermore, this study is useful to researchers and academicians in finding more evidence on the determinants of Malaysia Stock market.