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The dynamic adjustments of stock prices to inflation disturbances

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  • Valcarcel, Victor J.

Abstract

While theoretical predictions establish a strong positive relationship between equity prices and inflation, finding substantiating empirical evidence has been a difficult endeavor. Generally, the data suggests a weak negative relationship between stock prices and inflation. Aided by two different structural VAR specifications that allow for time variation in the covariance and drift of the system, this paper finds evidence that the weakly negative correlation between stock prices and US inflation results from offsetting effects of shocks to monetary policy and disturbances to the demand for financial assets. Since the 1960s, the stock price-inflation correlation is estimated to be relatively more stable than the volatility of either series, both of which have experienced substantial change—albeit volatility in US economic activity is estimated to have taken place far more gradually than that of stock prices. The volatilities of US economic activity, inflation, and stock prices all rose as a result of the financial crisis and the ensuing 2008–2009 Great Recession—with the level of inflation volatility estimates during the Great Recession comparable to those of the Great Inflation period of the 1970s. While it is shown that a traditional VAR approach would also predict a positive stock price response to inflationary disturbances, our time-varying approach enables us to uncover that during the 2008–2009 Great Recession period a stock price increase is more pronounced following inflationary shocks that stem from money supply, rather than money demand, disturbances—in contrast to the 1980–1982 recession where the magnitude of the stock price response to both shocks is more similar. These conclusions are qualitatively robust to changes in variable choice and measurement frequencies.

Suggested Citation

  • Valcarcel, Victor J., 2012. "The dynamic adjustments of stock prices to inflation disturbances," Journal of Economics and Business, Elsevier, vol. 64(2), pages 117-144.
  • Handle: RePEc:eee:jebusi:v:64:y:2012:i:2:p:117-144
    DOI: 10.1016/j.jeconbus.2011.11.002
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    References listed on IDEAS

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    Citations

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    Cited by:

    1. Nikolaos Antonakakis & Rangan Gupta & Aviral K. Tiwari, 2016. "Time-Varying Correlations between Inflation and Stock Prices in the United States over the Last Two Centuries," Working Papers 201605, University of Pretoria, Department of Economics.
    2. Jamal Bouoiyour & Refk Selmi, 2017. "Are Trump and Bitcoin Good Partners?," Papers 1703.00308, arXiv.org.
    3. Valcarcel, Victor J., 2013. "Exchange rate volatility and the time-varying effects of aggregate shocks," Journal of International Money and Finance, Elsevier, vol. 32(C), pages 822-843.
    4. Konstantakis, Konstantinos & Michaelides, Panayotis G., 2014. "Combining Input-Output (IO) analysis with Global Vector Autoregressive (GVAR) modeling: Evidence for the USA (1992-2006)," MPRA Paper 67111, University Library of Munich, Germany.
    5. repec:eee:riibaf:v:42:y:2017:i:c:p:1-8 is not listed on IDEAS
    6. Konstantakis, Konstantinos N. & Michaelides, Panayotis G., 2014. "Transmission of the debt crisis: From EU15 to USA or vice versa? A GVAR approach," Journal of Economics and Business, Elsevier, vol. 76(C), pages 115-132.
    7. Bosupeng, Mpho, 2014. "Sensitivity Of Stock Prices To Money Supply Dynamics," MPRA Paper 77924, University Library of Munich, Germany, revised 2014.
    8. Aviral Kumar Tiwari & Juncal Cunado & Rangan Gupta & Mark E. Wohar, 2017. "Are Stock Returns an Inflation Hedge for the UK? Evidence from a Wavelet Analysis Using Over Three Centuries of Data," Working Papers 201735, University of Pretoria, Department of Economics.
    9. Valcarcel, Victor J. & Wohar, Mark E., 2013. "Changes in the oil price-inflation pass-through," Journal of Economics and Business, Elsevier, vol. 68(C), pages 24-42.

    More about this item

    Keywords

    Real stock prices; The Great Moderation; Stochastic volatility; Markov Chain Monte Carlo; Structural vector autoregressions; Parameter instability; Structural change;

    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • E50 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - General
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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