Inflation and Stock Prices: No Illusion

Campbell and Vuolteenaho (2004) use VAR results to advocate inflation illusion as the explanation for the positive association between inflation and the dividend yield. Contrary to their results, we find that a fully rational dynamic general equilibrium model can generate a positive correlation between the dividend yield and inflation of comparable size to its data counterpart. The model results support a proxy hypothesis, according to which, a third factor, which in our model represents technology shocks, moves both inflation and the dividend yield in the same direction, resulting in a positive correlation between the two. The VAR structure of our model solutions makes it possible to decompose the dividend yield into the long-run expected dividend growth rate and the discount rate components, so that their relative importance can be studied.