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Disappearing money illusion

Author

Listed:
  • Tom Engsted

    (Aarhus University and CREATES)

  • Thomas Q. Pedersen

    (Aarhus University and CREATES)

Abstract

In long-term US stock market data the price-dividend ratio strongly predicts future inflation with a positive slope coefficient up to the mid 1970s. Thereafter, the predictability turns negative. We argue that this phenomenon reflects money illusion that disappears during the 1970s. We develop a consumption-based asset pricing model with recursive preferences and either money illusion or inflation non-neutrality that can explain the predictive patterns. The model is also consistent with a structural shift around the mid 1970s in the real interest rate - inflation relationship, thus supporting the hypothesis of disappearing money illusion at that time.

Suggested Citation

  • Tom Engsted & Thomas Q. Pedersen, 2018. "Disappearing money illusion," CREATES Research Papers 2018-24, Department of Economics and Business Economics, Aarhus University.
    • Handle: RePEc:aah:create:2018-24
    as

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    References listed on IDEAS

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    More about this item

    Keywords

    Modigliani-Cohn money illusion; predictive regressions; long-run risk; inflation non-neutrality;
    All these keywords.

    JEL classification:

    • C22 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes
    • 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
    • G17 - Financial Economics - - General Financial Markets - - - Financial Forecasting and Simulation

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