IDEAS home Printed from https://ideas.repec.org/
MyIDEAS: Login to save this article or follow this journal

Stock returns and inflation revisited: An evaluation of the inflation illusion hypothesis

  • Lee, Bong Soo
Registered author(s):

    Several hypotheses have been proposed to explain the stock return-inflation relation. The Modigliani and Cohn's inflation illusion hypothesis has received renewed attention. Another hypothesis is the two-regime hypothesis. We reexamine these hypotheses using long sample data of the US and international data. We find that the inflation illusion hypothesis can explain the post-war negative stock return-inflation relation, but it is not compatible with the pre-war positive relation. Using a structural VAR identification method, we show that there are two regimes with positive and negative stock return-inflation relations not only in each period of the US but also in every developed country we consider. This seems inconsistent with the inflation illusion hypothesis that predicts only a negative relation.

    If you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.

    File URL: http://www.sciencedirect.com/science/article/B6VCY-4XRYVHC-2/2/d76156323d31f364db55ff08c6534c2d
    Download Restriction: Full text for ScienceDirect subscribers only

    As the access to this document is restricted, you may want to look for a different version under "Related research" (further below) or search for a different version of it.

    Article provided by Elsevier in its journal Journal of Banking & Finance.

    Volume (Year): 34 (2010)
    Issue (Month): 6 (June)
    Pages: 1257-1273

    as
    in new window

    Handle: RePEc:eee:jbfina:v:34:y:2010:i:6:p:1257-1273
    Contact details of provider: Web page: http://www.elsevier.com/locate/jbf

    References listed on IDEAS
    Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:

    as in new window
    1. Martin Feldstein, 1978. "Inflation and the Stock Market," NBER Working Papers 0276, National Bureau of Economic Research, Inc.
    2. Brandt, Michael W. & Wang, Kevin Q., 2003. "Time-varying risk aversion and unexpected inflation," Journal of Monetary Economics, Elsevier, vol. 50(7), pages 1457-1498, October.
    3. Olivier Jean Blanchard & Danny Quah, 1988. "The Dynamic Effects of Aggregate Demand and Supply Disturbances," NBER Working Papers 2737, National Bureau of Economic Research, Inc.
    4. John Y. Campbell, 1990. "A Variance Decomposition for Stock Returns," NBER Working Papers 3246, National Bureau of Economic Research, Inc.
    5. Chen, Shiu-Sheng, 2009. "Predicting the bear stock market: Macroeconomic variables as leading indicators," Journal of Banking & Finance, Elsevier, vol. 33(2), pages 211-223, February.
    6. Ammer, John & Campbell, John, 1993. "What Moves the Stock and Bond Markets? A Variance Decomposition for Long-Term Asset Returns," Scholarly Articles 3382857, Harvard University Department of Economics.
    7. Polk, Christopher & Thompson, Samuel & Vuolteenaho, Tuomo, 2006. "Cross-sectional forecasts of the equity premium," Journal of Financial Economics, Elsevier, vol. 81(1), pages 101-141, July.
    8. Kaul, Gautam, 1990. "Monetary Regimes and the Relation between Stock Returns and Inflationary Expectations," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 25(03), pages 307-321, September.
    9. Stulz, Rene M, 1986. " Asset Pricing and Expected Inflation," Journal of Finance, American Finance Association, vol. 41(1), pages 209-23, March.
    10. Hess, Patrick J & Lee, Bong-Soo, 1999. "Stock Returns and Inflation with Supply and Demand Disturbances," Review of Financial Studies, Society for Financial Studies, vol. 12(5), pages 1203-18.
    11. Danthine, Jean-Pierre & Donaldson, John B, 1986. "Inflation and Asset Prices in an Exchange Economy," Econometrica, Econometric Society, vol. 54(3), pages 585-605, May.
    12. Gurdip S. Bakshi & Zhiwu Chen, 1998. "Inflation, Asset Prices and the Term Structure of Interest Rates in Monetary Economies," Yale School of Management Working Papers ysm44, Yale School of Management.
    13. Perron, P. & Bai, J., 1995. "Estimating and Testing Linear Models with Multiple Structural Changes," Cahiers de recherche 9552, Universite de Montreal, Departement de sciences economiques.
    14. Bodie, Zvi, 1976. "Common Stocks as a Hedge against Inflation," Journal of Finance, American Finance Association, vol. 31(2), pages 459-70, May.
    15. Fama, Eugene F, 1981. "Stock Returns, Real Activity, Inflation, and Money," American Economic Review, American Economic Association, vol. 71(4), pages 545-65, September.
    16. Martin Feldstein, 1983. "Inflation, Tax Rules, and the Stock Market," NBER Chapters, in: Inflation, Tax Rules, and Capital Formation, pages 199-220 National Bureau of Economic Research, Inc.
    17. John Y. Campbell & Tuomo Vuolteenaho, 2004. "Inflation Illusion and Stock Prices," NBER Working Papers 10263, National Bureau of Economic Research, Inc.
    18. Marshall, David A, 1992. " Inflation and Asset Returns in a Monetary Economy," Journal of Finance, American Finance Association, vol. 47(4), pages 1315-42, September.
    19. Jushan Bai & Pierre Perron, 2003. "Computation and analysis of multiple structural change models," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 18(1), pages 1-22.
    20. Gultekin, N Bulent, 1983. " Stock Market Returns and Inflation: Evidence from Other Countries," Journal of Finance, American Finance Association, vol. 38(1), pages 49-65, March.
    21. Ritter, Jay R. & Warr, Richard S., 2002. "The Decline of Inflation and the Bull Market of 1982–1999," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 37(01), pages 29-61, March.
    22. Fama, Eugene F. & Schwert, G. William, 1977. "Asset returns and inflation," Journal of Financial Economics, Elsevier, vol. 5(2), pages 115-146, November.
    23. Lee, Bong-Soo, 1989. "Solving, estimating, and testing a nonlinear stochastic equilibrium model, with an example of the asset returns and inflation relationship," Journal of Economic Dynamics and Control, Elsevier, vol. 13(4), pages 499-531, October.
    24. Lee, Bong-Soo, 2003. " Asset Returns and Inflation in Response to Supply, Monetary, and Fiscal Disturbances," Review of Quantitative Finance and Accounting, Springer, vol. 21(3), pages 207-31, November.
    25. Fama, Eugene F, 1983. "Stock Returns, Real Activity, Inflation, and Money: Reply," American Economic Review, American Economic Association, vol. 73(3), pages 471-72, June.
    26. Randolph B. Cohen & Christopher Polk & Tuomo Vuolteenaho, 2005. "Money Illusion in the Stock Market: The Modigliani-Cohn Hypothesis," NBER Working Papers 11018, National Bureau of Economic Research, Inc.
    27. Kaul, Gautam, 1987. "Stock returns and inflation : The role of the monetary sector," Journal of Financial Economics, Elsevier, vol. 18(2), pages 253-276, June.
    28. Lee, Bong-Soo, 1992. " Causal Relations among Stock Returns, Interest Rates, Real Activity, and Inflation," Journal of Finance, American Finance Association, vol. 47(4), pages 1591-603, September.
    29. Cai, Yijie & Chou, Ray Yeutien & Li, Dan, 2009. "Explaining international stock correlations with CPI fluctuations and market volatility," Journal of Banking & Finance, Elsevier, vol. 33(11), pages 2026-2035, November.
    30. James, Christopher & Koreisha, Sergio & Partch, Megan, 1985. " A VARMA Analysis of the Causal Relations among Stock Returns, Real Output, and Nominal Interest Rates," Journal of Finance, American Finance Association, vol. 40(5), pages 1375-84, December.
    31. Kanas, Angelos, 2008. "On real interest rate dynamics and regime switching," Journal of Banking & Finance, Elsevier, vol. 32(10), pages 2089-2098, October.
    32. Kaul, Gautam & Seyhun, H Nejat, 1990. " Relative Price Variability, Real Shocks, and the Stock Market," Journal of Finance, American Finance Association, vol. 45(2), pages 479-96, June.
    Full references (including those not matched with items on IDEAS)

    This item is not listed on Wikipedia, on a reading list or among the top items on IDEAS.

    When requesting a correction, please mention this item's handle: RePEc:eee:jbfina:v:34:y:2010:i:6:p:1257-1273. See general information about how to correct material in RePEc.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Zhang, Lei)

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If references are entirely missing, you can add them using this form.

    If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    This information is provided to you by IDEAS at the Research Division of the Federal Reserve Bank of St. Louis using RePEc data.