Monetary policy and the stock market: Theory and empirical evidence

This paper gives a comprehensive review of the literature on the interactio n between real stock returns, inflation, and money growth, with a special e mphasis on the role of monetary policy. This is an area of research that ha s interested monetary and financial economists for a long time. Monetary ec onomists have been interested in the question whether money has any effect on real stock prices, while financial economists have investigated whether equity is a good hedge against inflation. Empirical studies show that money can be helpful in predicting future stock returns. Empirical evidence also suggest that equity is not a good hedge against inflation in the short run but may be so in the long run. The short-run negative relation between sto ck returns and inflation can easily be explained by theoretical models. If the central bank conducts a countercyclical monetary policy this will resul t in a negative relation between inflation and stock returns, while if it c onducts a procyclical policy we could observe a positive relation. Accordin g to both theoretical and empirical studies investors receive an inflation risk premium for holding equity.