Risk Premia and the Sources of Inflation

Abstract

THE PROCESS OF INFLATION is associated not only with a rising general price level, but also with uncertainty about its rate of change. It is the latter aspect of inflation that may give rise to risk premia on nominal assets as compared with a real safe asset. A possible framework for analyzing the structure of risk premia under inflationary conditions is the well-known Capital Asset Pricing Model (CAPM) developed by Sharpe and Lintner. Indeed, a number of papers have recently dealt with these risk premia by means of the CAPM framework or some close variety of it. We may mention the works of Roll [9], Sarnat [10], Fischer [4], Chen and Boness [1], and Friend, Landskroner, and Losq [5].1 The CAPM and its extentions to conditions of inflation use a microeconomic approach in a partial equilibrium analysis of the risk premia. A basic feature of the foregoing literature is the implicit treatment of inflation as exogenous. Alternatively, there is no theory to relate the real return on money (to be denoted 7r) to the other variables in the CAPM formulation. This leads to two important shortcomings. First, the covariance of 7r with the rates of return appears as completely arbitrary. Second, since X was considered as exogenous, the authors did not consider the need to include in their models the government's nominal transfer pay-