Prices and Returns: What Is the Role of Inflation?

64 Pages Posted: 29 Oct 2019 Last revised: 24 Aug 2020

See all articles by Yulong Sun

Yulong Sun

University of Science and Technology of China (USTC)

Date Written: November 20, 2018


We document that the dividend yield can predict future inflation across advanced economies. The inflation predictability reinforces the return predictability and reduces the dividend growth predictability. For example, dividend yields forecast nominal returns (but not nominal dividend growth), meanwhile, dividend yields forecast real dividend growth (but not real returns). The same results also hold for the earnings yields. To reproduce the inflation predictability, we first test three hypotheses (related to future growth prospect, risk aversion, and behavior bias) to justify the positive correlation among inflation and dividend yields. Results suggest expected inflation can explain most of the variations in future excess cash flows. Then we argue inflation risk is priced in the aggregate market and inflation should be regarded as the state variable. Therefore, we introduce inflation as the second long-run risk besides the consumption risk into the long-run risk model. The estimated model can reproduce both the inflation predictability and the documented asset pricing facts.

Keywords: Dividend yield; Inflation predictability; International equity markets; Long-run risk.

JEL Classification: G10

Suggested Citation

Sun, Yulong, Prices and Returns: What Is the Role of Inflation? (November 20, 2018). Proceedings of Paris December 2019 Finance Meeting EUROFIDAI - ESSEC, Available at SSRN: or

Yulong Sun (Contact Author)

University of Science and Technology of China (USTC)

No.96 Jinzhai Road
Hefei, Anhui 230026


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