TAILIEUCHUNG - Inflation and Stock Prices: No Illusion

Beginning with the third edition, Proudhon intends to consider doctrines on the stock market or the ―temple of speculation‖ that derive from his political and social writing. He wants to assess stock market speculation in relation to general social standards or ―public morals‖ and to ―economic development‖ of his era. The unrestrained speculative development during the first half of the 19th century is for Proudhon simply a reflection of a corrupted social and economic system and a forewarning of an insurmountable barrier for the economic mechanism that should deliver a just and sustainable society - ―the industrial republic.‖ The object. | CHAO WEI 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 dividend yields. Using a structural approach we find that a fully rational dynamic general equilibrium model can generate a positive correlation between dividend yields and inflation as observed in the data. The paper describes a channel by which the technology shock moves both inflation and dividend yields in the same direction resulting in a positive correlation between the two. JEL codes E44 G12 Keywords inflation illusion dividend yield inflation. The leading practitioner model of equity valuation the so-called Fed model implies that dividend yields as measured by the ratio of dividends or earnings to stock prices are highly positively correlated with inflation a prediction borne out by the empirical evidence presented by Asness 2000 2003 . Despite the empirical success of the Fed model it is difficult to justify theoretically why the dividend yield a real variable should covary with a nominal variable such as inflation. Three hypotheses have been put forward to explain this positive correlation. The first hypothesis is that inflation or the monetary authority s response to inflation damages the real economy and in particular lowers corporate profits. In this case the growth rate of real dividends declines in response to inflation driving up dividend yields. The second hypothesis associates high inflation with high real discount rates. Brandt and Wang 2003 present a model in which inflation makes investors more risk averse driving up the required equity premium and thus the real discount rate. Modigliani and Cohn 1979 propose a third hypothesis known as inflation illusion. According to their hypothesis stock market investors fail to understand the effect of I would like to thank Michael Bradley Brett Rayner Tara Sinclair Roberto Samaniego Herman Stekler Thomas Tallarini

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