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Stock returns and inflation revisited: An evaluation of the inflation illusion hypothesis

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  • Lee, Bong Soo

Abstract

Several hypotheses have been proposed to explain the stock return-inflation relation. The Modigliani and Cohn's inflation illusion hypothesis has received renewed attention. Another hypothesis is the two-regime hypothesis. We reexamine these hypotheses using long sample data of the US and international data. We find that the inflation illusion hypothesis can explain the post-war negative stock return-inflation relation, but it is not compatible with the pre-war positive relation. Using a structural VAR identification method, we show that there are two regimes with positive and negative stock return-inflation relations not only in each period of the US but also in every developed country we consider. This seems inconsistent with the inflation illusion hypothesis that predicts only a negative relation.

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  • Lee, Bong Soo, 2010. "Stock returns and inflation revisited: An evaluation of the inflation illusion hypothesis," Journal of Banking & Finance, Elsevier, vol. 34(6), pages 1257-1273, June.
    • Handle: RePEc:eee:jbfina:v:34:y:2010:i:6:p:1257-1273
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