Disappearing Money Illusion

Abstract

In long-term US stock market data the price-dividend ratio strongly predicts future inflation with a positive slope coefficient up to the mid 1970s. Thereafter, the predictability turns negative. We argue that this phenomenon reflects money illusion that disappears during the 1970s. We develop a consumption-based asset pricing model with recursive preferences and either money illusion or inflation non-neutrality that can explain the predictive patterns. The model is also consistent with a structural shift around the mid 1970s in the real interest rate - inflation relationship, thus supporting the hypothesis of disappearing money illusion at that time.

Keywords: Modigliani-Cohn money illusion, predictive regressions, long-run risk, inflation non-neutrality

JEL Classification: C22, E31, E44, G12, G17