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Disappearing money illusion

Tom Engsted () and Thomas Q. Pedersen ()
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Thomas Q. Pedersen: Aarhus University and CREATES, Postal: Department of Economics and Business Economics, Fuglesangs Allé 4, 8210 Aarhus V, Denmark

CREATES Research Papers from Department of Economics and Business Economics, Aarhus University

Abstract: In long-term US stock market data the price-dividend ratio strongly predicts future inflation with a positive slope coefficient up to the mid 1970s. Thereafter, the predictability turns negative. We argue that this phenomenon reflects money illusion that disappears during the 1970s. We develop a consumption-based asset pricing model with recursive preferences and either money illusion or inflation non-neutrality that can explain the predictive patterns. The model is also consistent with a structural shift around the mid 1970s in the real interest rate - inflation relationship, thus supporting the hypothesis of disappearing money illusion at that time.

Keywords: Modigliani-Cohn money illusion; predictive regressions; long-run risk; inflation non-neutrality (search for similar items in EconPapers)
JEL-codes: C22 E31 E44 G12 G17 (search for similar items in EconPapers)
Date: 2018-08-21
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Persistent link: https://EconPapers.repec.org/RePEc:aah:create:2018-24

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