Disappearing Money Illusion

44 Pages Posted: 24 Aug 2018

See all articles by Tom Engsted

Tom Engsted

University of Aarhus - CREATES

Thomas Quistgaard Pedersen

Aarhus University - CREATES

Date Written: August 17, 2018

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

Suggested Citation

Engsted, Tom and Pedersen, Thomas Quistgaard, Disappearing Money Illusion (August 17, 2018). Available at SSRN: https://ssrn.com/abstract=3233425 or http://dx.doi.org/10.2139/ssrn.3233425

Tom Engsted (Contact Author)

University of Aarhus - CREATES ( email )

School of Economics and Management
Building 1322, Bartholins Alle 10
DK-8000 Aarhus C
Denmark

Thomas Quistgaard Pedersen

Aarhus University - CREATES ( email )

School of Economics and Management
Building 1322, Bartholins Alle 10
DK-8000 Aarhus C
Denmark

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