An Empirical Evaluation of the Friedman Hypothesis of Inflation on Capital Asset Pricing

Abstract

AbstractAn empirical model incorporating the Friedman inflation uncertainty hypothesis is evaluated on capital asset pricing in conjunction with the covariance effect of the Fisher inflation hypothesis. The Fisher‐Friedman capital asset pricing empirical model (FFCAPM) is compared to the capital asset pricing model (CAPM) and the Chen‐Boness (C‐B) model for explanatory power and significance over three periods. The FFCAPM performed better than the two competing models in explaining the variation in equity returns. The Friedman hypotheses of a positive economy‐wide inflation adjustment and a negative inflation uncertainty impact are supported. A firm‐specific inflation response of Fisher inflation covariance was also supported. These results indicate that empirical support for the Fisher effect may be limited given the normal testing procedure of simply adding an inflation term as in previous studies.