Asset Pricing and Expected Inflation



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    • Professor, College of Administrative Science, Ohio State University. I am grateful for useful comments from the participants of seminars at the University of Toronto, the Ohio State University, the University of Minnesota, and at the European Finance Meetings in Bern, Switzerland. I also thank K. C. Chan and Bill Schwert for useful discussions, and an anonymous referee for useful comments.


This paper provides an equilibrium model in which expected real returns on common stocks are negatively related to expected inflation and money growth. It is shown that the fall in real wealth associated with an increase in expected inflation decreases the real rate of interest and the expected real rate of return of the market portfolio. The expected real rate of return of the market portfolio falls less, for a given increase in expected inflation, when the increase in expected inflation is caused by an increase in money growth rather than by a worsening of the investment opportunity set. The model has empirical implications for the effect of a change in expected inflation on the cross-sectional distribution of asset returns and can help to understand why assets whose return covaries positively with expected inflation may have lower expected returns. The model also agrees with explanations advanced by Fama [5] and Geske and Roll [10] for the negative relation between stock returns and inflation.