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A New Keynesian Q Theory and the Link Between Inflation and the Stock Market

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  • Pierlauro Lopez

    (Banque de France)

Abstract

I show that when prices are sticky the Q theory of firms' behavior predicts that market-book ratios increase as inflation expectations diminish, holding investment fixed. In the data stock prices and investment correlate poorly precisely when stock prices and inflation move in opposite directions. Therefore, this New Keynesian Q (NKQ) theory can rationalize parsimoniously the time-varying correlation between investment and stock prices, and hence the time-series failure of the benchmark Q theory of investment. I estimate and test the NKQ equation by matching the volatility and return forecasting ability of predicted and actual stock prices, which are weak implications of the theory with strong economic and statistical content. Formal tests cannot reject the hypothesis that stock prices and a linear combination of investment and inflation move on the same news about the future. Along many dimensions the simple NKQ equation links well asset prices and macroeconomic variables. (Copyright: Elsevier)

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  • Pierlauro Lopez, 2018. "A New Keynesian Q Theory and the Link Between Inflation and the Stock Market," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 29, pages 85-105, July.
    • Handle: RePEc:red:issued:16-134
    DOI: 10.1016/j.red.2017.12.008
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    2. J. David Lopez-Salido & Francisco Vazquez-Grande & Pierlauro Lopez, 2015. "Macro-Finance Separation by Force of Habit," 2015 Meeting Papers 980, Society for Economic Dynamics.

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    More about this item

    Keywords

    Nominal rigidities and asset prices; Return forecastability; Misspecification; Firm-specific capital; Money illusion;
    All these keywords.

    JEL classification:

    • E22 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Investment; Capital; Intangible Capital; Capacity
    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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