Expected Inflation and Equity Prices: A Structural Econometric Approach

Abstract

The purpose of the present paper is to investigate the effects of expected inflation on the general level of common stock prices using a structural rather than a reduced-form approach. To this end, an aggregative partial-equilibrium structural econometric model of the U.S. equity market is constructed using quarterly flow-of-funds data. The primary endogenous variable in this model is the Standard and Poor's Index of 500 Common Stock Prices, P. After passing several standard validation exercises he model is used to perform a number of simulation experiments designed o assess the impact of expected inflation on P. To anticipate, we find that increases in expected inflation depress current equity prices by bout the same amount as found in a related study of Modigliani and Cohn: a l00 basis point increase in expected inflation, holding real interest rates constant, is predicted to lower the general level of equity prices by 7.8%. In the course of constructing the structural equity market model equity demand equations are estimated for households, life insurance companies, open-end investment companies, property and casualty insurance companies, and state and local government retirement systems. Equations are also estimated for the demand for mutual fund shares by households and equity issues by U.S. nonfinancial corporations.