Money Illusion in the Stock Market: The Modigliani-Cohn Hypothesis

Randolph B. Cohen · Tuomo Vuolteenaho

205 citations0/0 files storedThe Quarterly Journal of Economics

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Financial Markets and Investment Strategies Monetary Policy and Economic Impact Economic theories and models

Abstract

Modigliani and Cohn hypothesize that the stock market suffers from money illusion, discounting real cash flows at nominal discount rates. While previous research has focused on the pricing of the aggregate stock market relative to Treasury bills, the money-illusion hypothesis also has implications for the pricing of risky stocks relative to safe stocks. Simultaneously examining the pricing of Treasury bills, safe stocks, and risky stocks allows us to distinguish money illusion from any change in the attitudes of investors toward risk. Our empirical results support the hypothesis that the stock market suffers from money illusion.

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References

1964CAPITAL ASSET PRICES: A THEORY OF MARKET EQUILIBRIUM UNDER CONDITIONS OF RISK*1992The Cross-Section of Expected Stock Returns 1973Risk, Return, and Equilibrium: Empirical Tests 1975THE VALUATION OF RISK ASSETS AND THE SELECTION OF RISKY INVESTMENTS IN STOCK PORTFOLIOS AND CAPITAL BUDGETS**This paper is another in a series of interrelated theoretical and statistical studies of corporate financial and investment policies being made under grants from the Rockefeller Foundation, and more recently the Ford Foundation, to the Harvard Business School. The generous support for this work is most gratefully acknowledged. The author is also much indebted to his colleagues Professors Bishop, Christenson, Kahr, Raiffa, and (especially) Schlaifer, for extensive discussion and commentary on an earlier draft of this paper; but responsibility for any errors or imperfections remains strictly his own.[Professor Sharpe's paper, “Capital Asset Prices: A Theory of Market Equilibrium Under Conditions of Risk” (Journal of Finance, September 1964) appeared after this paper was in final form and on its way to the printers. My first section, which parallels the first half of his paper (with corresponding conclusions), sets the algebraic framework for sections II, III and VI, (which have no counterpart in his paper) and for section IV on the equilibrium prices of risk assets, concerning which our results differ significantly for reasons which will be explored elsewhere. Sharpe does not take up the capital budgeting problem developed in section V below.]1995The Limits of Arbitrage 1968THE PERFORMANCE OF MUTUAL FUNDS IN THE PERIOD 1945–1964 1972Capital Market Equilibrium with Restricted Borrowing 1972The capital asset pricing model: Some empirical tests

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