Review of Quantitative Finance and Accounting, 21: 207–231, 2003
2003 Kluwer Academic Publishers. Manufactured in The Netherlands.
Asset Returns and Inﬂation in Response to Supply,
Monetary, and Fiscal Disturbances
Department of Finance, Bauer College of Business, University of Houston, Houston, TX 77204-6021, USA
Abstract. This paper identiﬁes sources of asset returns (stock returns and interest rates) and inﬂation relations.
We ﬁnd that the relation between asset returns and inﬂation is driven by three types of disturbances to the economy.
We interpret them as due to supply disturbances and two types of demand—monetary and ﬁscal—disturbances.
In post-war U.S. data, supply and ﬁscal disturbances drive a negative stock return-inﬂation relation, whereas
monetary disturbances generate a positive stock return-inﬂation relation. However, all three types of disturbances
generate a negative interest rate-inﬂation relation. Depending on the interaction of the three types of shocks, we
observe different correlations between asset returns and inﬂation in post- and pre-World War II U.S. data.
Keywords: asset returns, inﬂation, identiﬁcation, structural VAR
JEL Classiﬁcation: G12, C32, E44
The relationship between inﬂation and returns to such ﬁnancial assets as stocks and bonds
has been an important issue for many years. Irving Fisher (1930) points out that the nominal
interest rate fully reﬂects the available information concerning the future values of the rate
of inﬂation (called the “Fisher hypothesis”). Economists thought that this hypothesis might
also hold for the stock return- inﬂation relationship.
Regarding the relation between inﬂation and interest rates, Fama (1975) presents evidence
that, at least during the 1953–71 period, expected real returns on one- to six-month Treasury
bills are constant and that nominal rates summarize all the information about future inﬂation
rates. His ﬁnding seems consistent with the Fisher hypothesis but is at variance with other
studies that support the view that the real rate of interest varies over time and can be related
to economic variables such as real output, monetary and ﬁscal policies, and are criticized
by others (e.g., Joins, 1977; Nelson and Schwert, 1977).
Contrary to the Fisher hypothesis, many empirical studies report a negative relation
not only between inﬂation and real interest rates but also between inﬂation and real stock
returns in the post-war data of the U.S. and other countries.
However, the observed negative
correlation between real interest rates and inﬂation is consistent with the arguments of
several theoretical models including Mundell (1963), Tobin (1965), and Stulz (1986). Some
theoretical studies present an equilibrium framework in which an expansionary monetary
policy and the accompanying inﬂation increase nominal rates of interest but decrease real
interest rates, which is consistent with empirical observations (e.g., Krugman, Persson and