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Inflation Illusion and Stock Prices

John Campbell () and Tuomo Vuolteenaho

No 10263, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: We empirically decompose the S&P 500's dividend yield into (1) a rational forecast of long-run real dividend growth, (2) the subjectively expected risk premium, and (3) residual mispricing attributed to the market's forecast of dividend growth deviating from the rational forecast. Modigliani and Cohn's (1979) hypothesis and the persistent use of the Fed model' by Wall Street suggest that the stock market incorrectly extrapolates past nominal growth rates without taking into account the impact of time-varying inflation. Consistent with the Modigliani-Cohn hypothesis, we find that the level of inflation explains almost 80% of the time-series variation in stock-market mispricing.

JEL-codes: G12 G14 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cfn, nep-fin and nep-fmk
Date: 2004-02
Note: EFG ME AP
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Published as Campbell, John Y. and Tuomo Vuolteenaho. "Inflation Illusion And Stock Prices," American Economic Review, 2004, v94(2,May), 19-23.

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