Financial Modeling

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American Finance Association

Causal Relations Among Stock Returns, Interest Rates, Real Activity, and Inflation Author(s): Bong-Soo Lee
Reviewed work(s):
Source: The Journal of Finance, Vol. 47, No. 4 (Sep., 1992), pp. 1591-1603 Published by: Blackwell Publishing for the American Finance Association Stable URL: .

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Causal Relations Among Stock Returns,
Interest Rates, Real Activity, and
Using a multivariate vector-autoregression(VAR)approach,this paper investigates causal relations and dynamic interactions among asset returns, real activity, and inflation in the postwar United States. Majorfindings are (1) stock returns appear Granger-causallyprior and help explain real activity, (2) with interest rates in the VAR, stock returns explain little variation in inflation, although interest rates explain a substantial fraction of the variation in inflation, and (3) inflation explains little variation in real activity. These findings seem more compatible with Fama (1981) than with Geske and Roll (1983) or with Ram and Spencer (1983).

VARIOUS HEORETICALRAMEWORKS AVE been developed to explain the negaT F
tive correlations observed between inflation and real asset returns in the postwar period. In light of the Fisher hypothesis, and of the commonly held view that stocks and bonds should be a hedge against inflation, these relations are indeed puzzling. Fama (1981), Geske and Roll (1983), Ram and Spencer (1983), James, Koreisha, and Partch (1985), Stulz (1986), and Kaul (1987) all attempt to explain the negative association between stock returns and inflation; and Fama and Gibbons (1982) attempt to explain the negative association between inflation and real interest rates.

Fama (1981) hypothesizes that the negative correlation between stock returns and inflation is not a causal relation but that it is proxying for a positive relation between stock returns and real activity and is induced by a negative relation between real activity and inflation. Geske and Roll (1983) argue that stock returns cause (or signal) changes in inflationary expectations because of a chain of macroeconomic events. When stock prices decline in response to anticipated changes in economic conditions, the government, given largely fixed expenditures, will tend to run a deficit. To the extent that the deficit is monetized, expected inflation will rise. Ram and Spencer (1983), however, find evidence of unidirectional causality from inflation to stock returns. Using a vector autoregressive-moving average (VARMA) model, James, Koreisha, and Partch (1985) examine simultaneously the causal links between stock returns, real activity, money supply, and inflation. They find evidence that stock returns signal both changes in real activity and changes in the monetary base, which suggests a link between money supply and real * Department of Finance, Carlson School of Management, University of Minnesota. I would like to thank an anonymous referee and editor for their many helpful comments and advice.


The Journal of Finance


activity that is consistent with the money supply explanation offered by Geske...
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