Inflation and Asset Prices

Abstract

Changes in the general level of prices and inflation have profound effects on asset prices. There are several reasons for these effects and the influence differs depending on the source of the inflation and whether it is expected or not. To understand these effects, it is important to clarify what is meant by inflation, the pure theory of the sources of inflation, how inflation affects goods and services prices and how it affects the assets that are used to finance production, both equity prices and fixed income assets. This article reviews the theory of inflation, its sources and effects on asset prices, especially equity, bond and real asset prices. The simplest and broadest economic model suggests that money is a veil and that changes in its value, the price level, and its rate of depreciation, inflation, have no real effects on the economy, especially asset prices and real rates of return on assets. There are a variety of reasons to expect that inflation is not “neutral,” however. This article focuses on several factors that give rise to real adverse effects of inflation on asset prices, including supply shocks that reduce wealth and raise prices, and tax effects of inflation that arise from a lack of full indexation of the tax system. Inflation has had large effects on asset prices in the United States, especially during the Great Inflation from 1965 to 1984. The evidence here supports these sources of real effects of inflation.

Keywords: Inflation, asset prices, supply shocks, real rate of interest, real rate of return on equity

JEL Classification: G0, E31, E44