Inflation and security returns

TL;DR: In this article, the impact of inflation on financial institutions and markets and its implications for investment policy are discussed. But the focus of this paper is on the effects of inflation in financial markets and not specifically on investment policy.

Abstract: WE ARE MEETING at a time when few matters are of more serious concern to students of finance and to members of the financial community than the impacts of inflation on our financial institutions and markets and its implications for investment policy. The evidence now available clearly indicates that substantial modifications and major new developments in our generally accepted models of security returns and capital market equilibria are going to be required to deal effectively with the impacts of inflation on our markets. The bulk of this address will be devoted to reviewing some of this evidence and suggesting some of the indicated modifications in our by-now conventional models and analytical frameworks. I will also advance some new theory which explains observed relations between inflation and equity market prices and returns, identify further effects of inflation on security markets and financial behavior, and suggest directions for further research on these issues. It will be useful, however, to view these further advances in our work in the perspective of a brief review of a few of the major landmarks in the development of our discipline. Although most of these basic earlier advances have not dealt specifically with inflation, they have provided a set of analytical frameworks and insights which form an essential base from which to develop a more probative understanding and analysis of the effects of inflation. Additional perspective comes from observing that-even though many of our central models and propositions as they stand are indeed seriously incomplete and biased, if not positively misleading, with respect to the impact of inflation on security returns-this earlier work has otherwise made very substantial and important advances in our understanding of financial markets and had a constructive impact on financial management and decision-making which should not be overlooked as we emphasize the need for further developments.