Stock Returns and Inflation Revisited

Abstract

The stock return-inflation relation has been an important issue in financial economics. Several hypotheses have been proposed to explain the relation. Among these, the Modigliani and Cohn's inflation illusion hypothesis has received renewed attention recently. Another hypothesis is the two-regime hypothesis. We reexamine these hypotheses using long sample data. We find that the Modigliani and Cohn hypothesis can explain the post-war negative relation between stock returns and inflation, but it is not easily compatible with the pre-war positive relation. We confirm the presence of two regimes in the relation between the pre- and post-war periods using an alternative structural VAR identification method.

Keywords: Stock Returns, Inflation, Inflation Illusion, Structural VAR

JEL Classification: G12, E44, C32