Inflation, the Interest Rate, and the Required Return on Equity

Abstract

Miller has analyzed capital structure in the presence of both corporate and personal taxes. The present work investigates the effect of inflation on both interest rates and equity re? turns when the Miller equilibrium condition is employed in a loanable funds model. Both an interest rate effect and a redistribution effect are derived. The interest rate effect forces the responsiveness of the interest rate to the inflation rate to be below that hypothesized by Darby. However, the redistribution effect may change this responsiveness in either direc? tion. I. Introduction The number of academic studies concerning inflation has grown in tandem with the price level. Researchers have considered the effect of the rate of infla? tion on the interest rate. The simplest models show that, without taxes, a 1 per? cent rise in the rate of anticipated inflation increases nominal interest rates by 1 percent. Recently, the effect of taxation on the relationship between interest rates and inflation has been investigated. For example, Darby [5] has pointed out that a 1 percent increase in the inflation rate should increase the after-tax interest rate by 1 percent, imply ing a greater movement in pre-tax interest rate. This result has been confirmed and extended by Gandolfi [13], Feldstein [8], and others. However, empirical evidence has not supported the theoretical work mentioned above. Beginning with Irving Fisher, many researchers have found that a 1 percent increase in the inflation rate yields less than a 1 percent increase in the pre-tax interest rate. The results of Feldstein-Eckstein [9] and Fama [7] suggest a one-to-one relationship. To our knowledge, there is no convincing evidence of a greater than one-to-one relationship. In addition to the lack of empirical validation, there is at least one conceptual shortcoming in past studies of inflation and interest rates. Most theories of corporate capital structure are not suitable to macroeconomic models. For * University of Pennsylvania, Philadelphia, PA 19104. This paper has benefited from the com? ments of M. Flannery, G. Gerber, R. Papetti, A. Santomero, and an anonymous JFQA referee.