Working Paper: NBER ID: w11018
Authors: Randolph B. Cohen; Christopher Polk; Tuomo Vuolteenaho
Abstract: Modigliani and Cohn [1979] hypothesize that the stock market suffers from money illusion, discounting real cash flows at nominal discount rates. While previous research has focused on the pricing of the aggregate stock market relative to Treasury bills, the money-illusion hypothesis also has implications for the pricing of risky stocks relative to safe stocks. Simultaneously examining the pricing of Treasury bills, safe stocks, and risky stocks allows us to distinguish money illusion from any change in the attitudes of investors towards risk. Our empirical resuts support the hypothesis that the stock market suffers from money illusion.
Keywords: money illusion; stock market; Modigliani-Cohn hypothesis; inflation; CAPM
JEL Codes: G12; G14; N22
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| inflation (E31) | expected equity premium (G12) |
| money illusion (E41) | mispricing of stocks (G10) |
| inflation (E31) | mispricing of stocks (G10) |
| expected returns (G17) | beta (C46) |
| money illusion (E41) | systematic deviation in stock pricing (G12) |
| high inflation (E31) | stock market undervaluation (G17) |
| low inflation (E31) | stock market overvaluation (G10) |