Disappearing money illusion

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Abstract

In long-term US stock market data the price-dividend ratio strongly predicts future inflation with a positive slope coefficient up to the mid 1970s. Thereafter, the predictability turns negative. We argue that this phenomenon reflects money illusion that disappears during the 1970s. We develop a consumption-based asset pricing model with recursive preferences and either money illusion or inflation non-neutrality that can explain the predictive patterns. The model is also consistent with a structural shift around the mid 1970s in the real interest rate - inflation relationship, thus supporting the hypothesis of disappearing money illusion at that time.
Original languageEnglish
Place of publicationAarhus
PublisherInstitut for Økonomi, Aarhus Universitet
Number of pages44
Publication statusPublished - 21 Aug 2018
SeriesCREATES Research Paper
Number2018-24

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