Literature Review on Inflation and Stock Returns
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This chapter focuses on the literature review aspect of this study. It reviews issues around inflation and stock returns.
2.2.1 Conceptual Issues
Inflation has defined in many ways by different economist. According to Johnson, 1972, inflation is simply defined as sustained rise in general price level. Inflation is usually measured over periods that are sufficiently long to eliminate any bias arising from short term phenomena. Inflation is now worldwide, and it is one of the greatest challenges facing most nations in the 1980s. One significant feature of the present inflationary trend is its ability to defy solution in most countries (Ajayi and Ojo, 2006).
2.2.2 Sources of Inflationary Pressures
One of the major challenges facing economists today is the re-examination and classification of their views on the forces that produce large variations in price level. There has been in the last few years an abundance of literature on the subject of inflation (Ajayi and Ojo, 2006).
According to Ajayi and Tariba 1974, there are three major categories of causes. Namely;
- The monetarist explanation of inflation
- Cost push theories of inflation; and
- Excess demand theories of inflation
The monetarist explanation of inflation
The monetarists view inflation exclusively in terms of increases in the money supply. The monetarist explanation is build up from the quantity theory of money. The quantity theory based on the contribution of prominent economist like Irvin fisher, Alfred marshall, A.C. Pigou and Keynes in the early decades of the twentieth century. The fisher's equation of exchange, the Cambridge equation and the Chicago school of monetarists are major contribution of these economists. In recent years, there has been a resurgence of the quantity theory in what is known as monetarism, the most well-known advocate being Milton Friedman of the University of Chicago. The monetarists assert that the significant determinant aggregate spending is the supply of money. Hence, increases in the money supply are seen the important causes of inflation.
Cost Push theories of inflation
According to this view, the studies of institutional framework within which prices and wages are determined are vital when understanding inflationary process. The role of the trade union in securing increased wages is emphasized because it leads to increase in money value of national income and inflation. The trade unions use the threat of an all out strike to pressurize government and other employers of labour to increase their wages. This increase may lead to increase in cost of production which is passed on to the final consumers of goods and service in the form of higher prices. However, this cannot occur in a perfectly competitive market where labor unions cannot exercise tight control over the supply of labour and the substitution between labour and other factors of production are perfect in economic sense. The profit push inflation can also be seen as another version of cost push inflation. This is when firms maintain certain profit margin or mark-up which might become an important element in the inflationary process.
Excess Demand Theories
Excess demand is when the supply of goods and services falls short of the demand for them. Excess demand leads to rise in prices of goods and services because interested consumers engage in competitive bidding which result into higher prices. This view is better explained using the Keynesian analysis.
2.2.3 Effects of Inflation
Developing countries experiencing growth usually have some form of inflation. Some economists have argued that some form of inflation is inevitable for growth. The history of inflation has many instances of countries that have inflation without growth and others that have growth without inflation (Friedman, 1973).
Hinshaw (ed.) (1972) opined that inflation is an evil that should be avoided; suggest the following as the reason for this.
Firstly, inflation impairs the usefulness of money, and some cases it destroys its usefulness completely when the rate is too high. When this occur, contracts expressed in monetary term and goods and services that can be bought with a unit of money falls.
Secondly, inflation hinders effective distribution of income and wealth. Inflation has pervasive effect on the income of workers with fixed wages such as salary earners, pensioners and those whose income depend heavily on fixed-income assets like bonds. The present of inflation makes borrowers to gain while lenders loss. Since at the time when the borrower wants to repay his loan, the value of the exact amount would have being reduced because of inflation.
Thirdly, inflation may lead to balance of payment crisis. With inflation competitiveness and contraction of sales are weakened because of the upward pressure on prices and costs. Therefore, people would prefer to sell their goods in an economy with high inflationary rate than to buy in that economy.
Finally, the performance of an economy is distorted and destabilized because people are encouraged to accumulate inventories speculatively; there is also the issue of misallocation of resources and depressing effect on output and employment due to excessive bidding for real capital assets like land. However, as argued by many economists, inflation can serve as a catalyst for effective economic development since it may favour capital investment and thus increase the growth of potential output.
2.2.4 Stock Returns
Stock return may be defined as a measure of the return that a firm's management is able to earn on common stockholders' investment. Return on common stock equity is calculated by dividing the net income minus preferred dividends by the owners' equity minus the par value of any preferred stock outstanding. For firms with no preferred stock, return on common stock equity is identical to return on equity. The American Heritage® Dictionary of Business Terms Copyright © 2010
2.2.5 Determinants of Stock Returns
Stock returns are volatile overtime. According to Emenike, 2010, Volatility clustering occurs when large stock price changes are followed by large price change, of either sign, and small price changes are followed by periods of small price changes. However, Robert and Nardin (1996) suggested that there is possibility for the determinants of differential stock returns to be stable over time, and the forecasting power of the expected return factor model may also be high. Interestingly, they also found out that there seems to be a great deal of commonality across markets in firm characteristics that explain differences in expected returns. This is true in spite of the fact that the monthly “payoffs” to these characteristics are not significantly correlated across the five countries examined. Thus, the determinants of expected stock returns appear to be common across different time periods and across different markets. Based on this, they suggest the following as possible determinants of stock returns; riskiness of an assets, interest rate, exchange rate, money supply and trading volume.
Riskiness of an Asset: return on an asset or stock; depend on how risky the stocks are. Romer (2006) opined that the aspect of riskiness that matter to the decision of whether to hold more of an asset is the relationship between asset's payoff and consumption. Therefore, when making marginal decision on which assets to invest in, the expected return of the asset matters.
Interest Rate: interest is one of the major determinants of returns on stocks or assets. An increase in domestic interest rate (Id) above world interest rate (Iw) would lead to increase in inflow of capital to the domestic country. This inflow of capital into the economy might be diverted into the capital market and this will increase the demand for stock with supply remaining constant. This would lead to excess demand which result into increase in the price of stock. An increase in stock prices, affect the return on the stocks (Pilbeam, 2001).
Exchange Rate: empirical studies such as Abdalla and Murinde 1997; Yang 2001; and Grambovas 2003 suggest that there is long-run relationship between exchange rate and stock returns. An increase in exchange rate (depreciation) makes the price of stock to fall thereby increasing the volume of stock being purchase and this would have positive effect on the return of stocks. The reverse is the case when there is exchange rate appreciation.
Money Supply: Homa and Jaffee 1971; Rozeff 1974; and Darrat 1990 in different studies, suggested that stock prices are affect by changes in money supply which directly affect stock prices through changes in portfolio and indirectly affect stocks prices through variables of real activity in the economy. Also, an increase or decrease in money supply, can lead to increase or decrease in money in the system. This can cause situation where more money would be chasing few stocks or less money chasing more stocks.
Trading Volume: the volume of stock traded in the stock market has positive impact on stock returns. The higher the volume of traded stocks, the higher the rate of return stocks from the stocks traded and vice versa. This argument has been proven empirically by Karpoff (1987), Hans (1986) and Chalen (1993).
2.3 Theoretical Literature Review on Inflation and Stock Returns
2.4 Empirical Literature Review on Inflation and Stock Returns
The empirical literature on the impact of inflation on stock returns has witness major contribution by different scholars over the years. But the empirical evidence provided by most of these studies has been mixed, and a consensus has not yet emerged. While studies like Pierrel and Kwok (1992), Geske and Roll (1983), Floros (2002), Ugur (2005), Yeh and Chi (2009), Pesaran et al (2001), Den Haan (2000), Crosby (2001), Syros (2001), Roohi and Khalid (2002) among others have found a negative relationship between inflation and stock returns; Boudoukh and Richardson (1993), Graham (1996), Choudhry (2001), Patra and Posshakwale (2006) and Lee et al (2000) among others reported positive relationship between these variables.
Concerning the review of the approaches of modeling the effect of inflation on stock returns, Pierrel and Kwoks (1992) estimates and tests the alternative versions of hypothesis that explain the relationship between these two variables. The study employs the techniques of distributed lags in order to empirically arrive at a dynamic structure of inflation. Pierrel and Kwoks concluded that this dynamic structure conform to Fama (1981), Benderly and Zwick (1985), and Geske et al (1983) hypothesis that suggest a negative relationship between inflation and return on stocks.
Yeh and Chi (2009) in a different study also tested the validity of the various Hypotheses that explain this relationship. The empirical result of this study on 12 OECD countries shows that these countries exhibit a short-run negatively significant co-movement between stock returns and inflation. Moreover, countries like Australia, France, Ireland and Netherland do not display a long-run relationship between the two variables in equilibrium. This result is consistent with the hypotheses of Fama (1981), Modigliani et al (1979) and Feldstein (1980) which suggested that an increase in inflation reduces real returns on stock. This result is also in line with Caporale and Jung (1997) and Rapach (2002). They argue respectively that there exist a negative significant effect of inflation on real stock returns after controlling for output shock and that inflationary trends do not erode returns on stocks.
The fisher's Hypothesis was tested by Spyros (2002). The result reflects a contrary view that returns on stocks hedges inflation. This study shows that there is negative but not statistically significant relationship between inflation and stock returns in Greece from 1990 to 2000. In this same vein, Floros (2002) carried the same study on Greece economy and concluded that inflation and stocks in Greece are treated as independent variables because the result of the various test conducted show that there is no relationship between inflation and stock returns in Greece. Crosby (2001) investigate the relationship inflation and stock returns in Australia from 1875 to 1996 and found out that the Australian economy does not experience permanent changes in inflation or stock returns. The result shows that there exist short-run negative relationships between these two variables that depend on the period of time that is considered.
On the contrary, Lee et al (2000) examine the impact of German hyperinflation in the 1920s on stock returns. This result of this study show that the hyperinflation in Germany in early 1920s cointegrates with stock returns. The fundamental relationship between stocks returns and both realized and expected inflation is highly positive. They concluded that common stocks appear to be a hedge against inflation during this period. Choudhry (2001) in his study on the impact of inflation on stock returns in some selected Latin and Central American countries (Argentina, Chile, Mexico and Venezuela) from 1981-1996, reveal that there is one- to-one relationship between the current rate of nominal return and inflation for Argentina and Chile. Their result also reveals that the lag values of inflation affect stock returns and this result infer that stocks act as a hedge against inflation.
In a similar submission, Patra and poshakwale (2006) conducted a study on the impact of economic variables on market returns in Greece from 1990 to 1999. Empirical results show that some macroeconomic variable like money supply, inflation, volume of trade and exchange have both short-run and long-run relationship with stock price in equilibrium in Greece while there was no short-run or long run relationship noticed between exchange rate and stock prices.
Ugur (2005) in a study on the effect of inflation on return on stocks in turkey from 1986 to 2000 reveal that expected inflation and real returns are not correlated. The results suggest there is a negative relationship between inflation and stock returns which may be caused by the negative impact of unexpected inflation on stock returns. This results did not contract Fisherian hypothesis because of the non correlation of inflation and real returns but the results is in line with the proxy hypothesis since a negative significant relationship exist between the two variables. Aperigis and Eleftheriou (2002) results also concurred that there is negative link between inflation and stock returns in Greece than in interest rate and stock returns. Similar study like Adrangi et al (1999) and sellin (2001) also support the proxy hypothesis. Khil and Lee (2000) in their study on ten pacific-rim countries and the US that all the countries except Malaysia reveal negative relationship between inflation and stock returns.
The tax-effects Hypothesis which asserts that there is negative relationship between inflation and stock returns was tested by Geske and Roll (1983). Empirical result from the reveal that random negative or positive real shock affects stock returns which in turn, signal higher or lower unemployment and lower or higher corporate earnings. This has effect on the personal and corporate tax revenue leading to increase or decrease in the treasury through borrowing from the public. The economy paid for this debt by expanding or contracting money growth and this would lead to higher or lower inflation. They concluded that random shocks on stock returns are both fiscal and monetary in nature in the U.S.A.
Roohi and Khalid (2002) considered the efficient market hypothesis and rational expectation theory to investigate the effect of inflation on stock returns. Empirical results of the study suggest that the relationship between real stock returns, unexpected inflation and unexpected growth are negatively significant. They concluded that the control of real output growth makes the negative relationship between these two variables to disappear over time.
2.5 Methodological Literature Review on Inflation and Stocks Returns
The empirical relation between inflation and stock returns has been investigated through various approaches since the 1970s. Some of the notable methodological techniques that are used in estimating such relationships range from the Ordinary Least Squares (OLS) method, Vector Auto-regression (VAR) approach, Auto-regressive integrated moving average (ARIMA) approach, Johansen cointegration test, Granger causality test, to Error Correction Model (ECM) and Autoregressive Distributed Lag (ARDL) bound Test techniques. However, studies like Roohi and Khalid (2002) made use of Full Information Maximum Likelihood (FIML). Moreover, another equally vital methodological question involves the appropriate measure of the relationship between inflation and stock returns that best explains the exact features of the Nigerian Economy. This is because most macroeconomic data in Nigeria have unit root since they are all integrated of order one.
Considering the study carried out on Greece by Syros (2001), he adopted Vector-Auto regressive (VAR) model and the cointegration test to confirm if there was any relationship between inflation and stock returns in emerging economy like Greece. Pierrel and Kwok (1992) investigated the relationship between stock returns and inflation in the United State between 1962-1992 using Vector- Autoregressive (VAR) model, unrestricted cointegation test and Granger Causality test. In another study, Crosby (2001), used Vector-Autoregressive (VAR) model, Ordinary Least Square (OLS) and correlation analysis to examine the relationship between inflation and stock returns in Australia from 1875-1996.
Floros (2002), investigated the relationship between stock returns and inflation in Greece from 1988-2002 by considering both the lag and lead periods of inflation and stock returns using Ordinary Least Square (OLS), Johansen Cointegration Test and Pairwise Granger Causality Test. In this same vein, Ugur (2005) used the Ordinary Least Square (OLS) and Standard Granger Causality to examine the relationship between inflation, stock returns and real activity in Turkey.
Choudhry (2001), estimate the impact of inflation on stock returns in some selected latin and Central American country using the Auto-Regressive Integrated Moving Average (ARIMA), unit root test and spectral regression model. Lee et al (2000); and Geske and Roll (1983), also used ARIMA, OLS and unit root test to investigate the effect of German hyperinflation and stock returns, and the impact of inflation on stocks returns in the USA respectively.
Patra and Poshakwale (2006) on the other hand, used the Error Correction Model (ECM), Johansen Cointegration Test and Pairwise Granger Causality Test to show if economic variables such as money supply interest rate, exchange rate, volume of trade and stock prices have impact on stock returns.
Yeh and Chi (2009) in their study on 12 OECD countries measures correlation at different forecast horizon by using Autoregressive Distributed Lag (ARDL) bound test, unit root test and confidence interval method to investigate the inflation illusion hypothesis that suggest that there is negative relationship between inflation and stock returns. Pesaran et al (2001) and Den Haan (2000) also employ the same technique and arrive at the same result.
Summary of Literature Review
Spyros .I. Spyrou
Vector-Autoregressive(VAR), Johansen Cointegration Test
Negative relationship between stock returns and inflation was found but not statistically significant.
Vector-Autoregressive(VAR), Ordinary Least Square (OLS) and Correlation
The level of price index is been affected permanently by shocks to the price level, therefore there exist negative relationship between inflation and stock returns depending on the period been considered
Ordinary Least Square (OLS), Johansen Cointegration Test and Pairwise Granger Causality Tests.
Inflation and stock returns in Greece are treated as independent variables because therefore there is no relationship between inflation and stock returns.
Theophano Patra and Sumil Poshakwale
Greece 1960- 1999
Error Correction Model (ECM), Joahansen Cointegration Test and Pairwise Granger Causality Test.
Some macroeconomic variables like money supply, interest rate, exchange rate and volume of trade have short-run relationship with stock prices.
Pierrel Silkos and Ben Kwok
Unrestricted cointegrating Vector-Autoregression (VAR) and Granger Causality Test.
The various testing of the three hypothesis stated based on Fama(1981), Benderly and Zwick (1985) and Geske et al (1983) shows that there is dynamic structure in inflation and stock returns.
Robert Geske and Richard Roll
Autoregressive Integrated Moving Average (ARIMA) and OLS.
Random negative or positive real shock affects stock return.
Roohi Ahmed and Khalid Mustapha
Efficient Market hypothesis and rational expectation theory
Full Information Maximum Likelihood (FIML)
The relationship between real stock returns and unexpected, inflation and unexpected growth are negatively significant.
Selected Latin and Central American Countries 1981-1996
Autoregressive Integrated Moving Average (ARIMA), Unit Root Test and Spectral Regression Method
There is a direct one-to-one relationship between the current rate of nominal return and inflation for Argentina and Chile.
S.R Lee, D.P Tang and Matthew Wong
Germany Early 1920s
Autoregressive Integrated Moving Average (ARIMA), OLS and Unit Root Test (Augmented Dickey Fuller)
Hyperinflation in Germany cointegrates with stock returns during this period and fundamental relationship between stock returns and both realized and expected inflation is highly positive.
Unit Root Test (ADF), standard Granger Causality Test and OLS.
Expected inflation and stock returns are not correlated. Therefore there is negative relationship between return on stocks and inflation.
Chih-chuan Yeh and Ching-Fan Chi
12 OECD Countries 1957-2003
Inflation illusion Hypothesis
Autoregressive Distributed Lag (ARDL) Bound Test, Unit Test (Ng and Perron) and confidence interval Method.
12 OECD countries exhibit a short-run negatively significant co-movement between inflation and stock returns. While countries like Austria, France, Ireland and Netherlands do not display a long-run relationship between the two variables in equilibrium.
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