A New Keynesian Q Theory and the Link between Inflation and the Stock Market

Abstract

I show that when prices are sticky the Q theory of firms' behavior predicts that market-book ratios increase as inflation expectations diminish, holding investment fixed. In the data stock prices and investment correlate poorly precisely when stock prices and inflation move in opposite directions. Therefore, this New Keynesian Q (NKQ) theory can rationalize parsimoniously the time-varying correlation between investment and stock prices, and hence the time-series failure of the benchmark Q theory of investment. To estimate and test the NKQ equation, I rely on weak implications of the theory with strong economic and statistical content by matching the volatility and return forecasting ability of predicted and actual stock prices. Formal tests cannot reject the hypothesis that stock prices and a linear combination of investment and inflation move on the same news about the future. Along many dimensions the simple NKQ equation links well asset prices and macroeconomic variables.

Keywords: Nominal rigidities and asset prices, Return forecastability, Misspecification, Firm-specific capital, Money illusion

JEL Classification: E22, E31, E44, G12