Irrelevance of Inflation: Six Stock Market Indices

What is the relation between inflation and stock returns? This paper tries to answer this question. The
working hypothesis is that inflation is not negatively related to stock returns, as is evidenced
empirically for the short run, nor is it positively related to stock returns, as long term analysis seems to
suggest, but that simply it is just irrelevant. The paper develops a theoretical model that excludes
inflation, and tests the statistical significance of including inflation in the model. The inquiry is
generalized to six stock market indices, and to three econometric procedures. Both unconstrained and constrained regressions are carried out. We find strong support for the irrelevance of inflation,
especially when the investor is sophisticated. Moreover, we prove and show that the correct null
hypothesis in the regression of inflation on real stock returns is that the inflation beta ought to be
insignificantly different from -1, and not insignificantly different from zero. Therefore the paper serves
to rehabilitate the proposition of inflation irrelevance, in opposition to the conviction of many
economists, and despite their resistance.

Author (s) Details

Dr. Samih Antoine Azar
Faculty of Business Administration and Economics, Haigazian University, Mexique Street, Kantari, Beirut, Lebanon.

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