Stock Returns and Inflation with Supply and Demand Disturbances

Abstract

We account for the relation between stock returns and inflation with two independent disturbances: supply shocks and demand shocks. Supply shocks reflect real output shocks and cause a negative relation between stock returns and inflation, while demand shocks are mainly due to monetary shocks and generate a positive relation between stock returns and inflation. We show, both theoretically and empirically, that the stock return–inflation relation varies over time and across countries, depending on the relative importance of the two types of shocks. Our empirical evidence is based on pre- and postwar periods in the United States, as well as the postwar period in the United Kingdom, Japan, Germany.

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