Fisher Equation and Modigliani-Cohn Hypothesis in the Financial Markets
Keywords:
Fisher Equation, Money Illusion, Modigliani-Cohn Hypothesis, Financial Markets, Inflation
Abstract
Fisher equation in its conventional form suggests that nominal interest rate is the sum of real interest rate and expected inflation and, as such, it has been utilized as a standard component in economic literature to predict the behavior of nominal and real interest rates or to analyze investment returns. Nevertheless, Fisher equation has its flaws well documented in the empirical literature. This paper focuses on enriching contemporary theoretical underpinnings by paying attention to Fisher´s illusory nature of nominal interest rate, revisiting original roots of Fisher equation, and contrasting them with modern conventional form of Fisher equation. Consequently, implications will be derived for the relevance of a particular form of Fisher equation. Another important contribution is the connection of Fisher’s equation with money illusion through Modigliani-Cohn hypothesis (1979). This phenomenon might be responsible for an imperfect adjustment of the interest rate to expected inflation, thereby leading to substantial implications in financial markets.
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References
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5. Bewley, T. F. (1999). Why Wages Don’t Fall During a Recession. Cambridge MA USA: Harvard University Press.
6. Bittschi, B. & Duppel, S. (2015). Did the introduction of the euro lead to money illusion? Empirical evidence from Germany. ZEW Discussion Papers No. 15-058, ZEW - ZentrumfürEuropäischeWirtschaftsforschung / Center for European Economic Research, https://doi.org/10.2139/ssrn.2661471
7. Blinder, A. (1995). On sticky prices: academic theories meet the real world. in N. G. Mankin (ed) Monetary Policy, Studies in Business Cycles, Vol 28, Chicago and London,University of Chicago Press.
8. Boudoukh, J. & Richardson, M. (1993). Stock Returns and Inflation: A Long-Horizon Perspective. American Economic Review, 83 (5), pp. 1346-55.
9. Brunnermeier, K. M. & Julliard, C. (2008). The Causes and Consequences of Recent Financial Market Bubbles. The Review of Financial Studies, 21(1), pp. 135-180, https://doi.org/10.3386/w12810
10. Campbell, J. & Vuolteenaho, T. (2004). Bad Beta, Good Beta. American Economic Review, 94(5), pp. 1249-1275.
11. Cannon, E. & Cipriani, G. (2006). ‘Euro-Illusion: a Natural Experiment. Journal of Money, Credit and Banking, 38 (5)., pp. 1391 – 1403.
12. Chen, C., Lung, P. P. & Wang, F. A. (2009). Stock Market Mispricing: Money Illusion or Resale Option. The Journal of Financial and Quantitative Analysis, 44 (5), pp. 1125-1147.
13. Cohen, R. B., Polk, C. & Vuolteenaho, T. (2005). Money Illusion in the Stock Market: The Modigliani-Cohn Hypothesis. The Quarterly Journal of Economics, 120(2), pp.639-668, doi.org/10.3386/w11018
14. Cohn, R. A. & Lessard, D. R. (1980). The Effect of Inflation on Stock Prices: International Evidence. WP No.11470 of University of Illinois at Chicago Circle and Massachusetts Institute of Technology presented at the September 1980 meetings of the American Economic and American Finance Associations in Denver, Colorado.
15. Chordia, C. & Shivakumar, L. (2005). Inflation Illusion and Post-Earnings-Announcement Drift. Journal of Accounting Research. 43(4), pp. 521-556.
16. Chytilova, H. (2018). Economic Literacy and Money Illusion, An Experimental Perspective, Routledge, ISBN 9780367594893.
17. Dimand, R.W. (1993). The Dance of the Dollar, Irving Fisher’s Monetary Theory of Economic Fluctuations, History of Economics Review, 20 (1), pp.161-172.
18. Engsted, T. & Pedersen, T. Q. (2016). The predictive power of dividend yields for future inflation: Money illusion or rational causes? CREATES Research Papers 2016-11, Department of Economics and Business Economics, Aarhus University, doi.org/10.2139/ssrn.3233425
19. Fama, E. F. (1976). Inflation Uncertainty and Expected Returns on Treasury Bills. Journal of Political Economy 84, no. 3, pp. 427-48.
20. Fama, E. F. (1975). Short-Term Interest Rates as Predictors of Inflation. American Economic Review 65, no. 3, pp. 269-82.
21. Fama, F. (1981). Stock Returns, Real Activity, Inflation, and Money, The American Economic Review, 71 (4), pp. 545-565.
22. Fehr, E. & Tyran, J. (2001). Does Money Illusion Matter? American Economic Review, American Economic Association, 91(5), pp.1239-1262, December, doi.org/10.1257/aer.91.5.1239
23. Fehr, E. & Tyran, J. (2005). “Expectations and the Effects of Money Illusion” In: Agarwal B. & Vercelli A. (Eds.): Psychology, Rationality and Economic Behavior. Challenging Standard Assumptions. International Economic Association, Ch. 8: pp.155-80, doi.org/10.1057/9780230522343_8
24. Fehr, E. & Tyran, J. (2007). Money Illusion and Coordination Failure, Games and Economic Behavior, Elsevier, vol. 58(2), pp. 246-268, February, doi.org/10.1016/j.geb.2006.04.005
25. Fehr, E. & Tyran, J. (2008). Limited Rationality and Strategic Interaction: The Impact of the Strategic Environment on Nominal Inertia, Econometrica, Econometric Society, vol. 76(2), pp.353-394, 03, doi.org/10.2139/ssrn.354580
26. Feldstein, M. (1980). Inflation and the Stock Market. American Economic Review 70(5), pp.839-847.
27. Fisher, I. (1896). Appreciation and Interest. Publication of the American Economic Association. 3rd series XI. 4, Reprinted Fairfield, NJ:Kelley, A. M. (1991).
28. Fisher, I. (1906). The Nature of Capital and Income. New York: Macmillan.
29. Fisher, I. (1913). A Compensated Dollar, The Quarterly Journal of Economics, vol.27, No.2, pp. 213-235.
30. Fisher, I. (1928). The Money Illusion, New York: Adelphi Publishers.
31. Fisher, I. (1930). The Theory of Interest, London: Macmillan.
32. Fortin, P. (2013). The Macroeconomics of Downward Nominal Wage Rigidity: A Review of the Issues and New Evidence for Canada. Cahiers de recherche WP No. 1309. Available at: http://www.cirpee.org/fileadmin/documents/Cahiers_2013/CIRPEE13-09.pdf
33. Gavriilidis, K. & Kgari, L. M. (2016). Stock Returns and Inflation, the Case of Botswana. Handbook of Frontier Markets. The European and African Evidence, pp. 27-38.
34. Gultekin, B. N. (1983). Stock Market Returns and Inflation: Evidence from Other Countries. The Journal of Finance, 38, (1), pp. 49-65.
35. Hirschleifer, J. (1970). Investment, Interest, and Capital. Englewood Cliffs, N.J.: Prentice-Hall.
36. Hogan, S. (2013). What Does Downward Nominal-Wage Rigidity Imply for Monetary Policy? Bank of Canada WP No.97-13, Bank of Canada. Available at: http://publications.gc.ca/collections/Collection/FB3-2-97-13E.pdf
37. Jureviciene, D. & Markelova, J. (2016). Assessment Of Money Illusion Impact On Individuals’ Economic Behaviour In Lithuania. European Scientific Journal, ESJ, 12(13), 1. https://doi.org/10.19044/esj.2016.v12n13p1
38. King, R. G. & Watson, M. W. (1997). Testing Long-run Neutrality," Economic Quarterly, Federal Reserve Bank of Richmond, 83(3), pp. 69-101.
39. Lee, B. S. (2010). Stock returns and inflation revisited: An Evaluation of the Inflation Illusion Hypothesis, Journal of Banking & Finance, 34 (6), pp. 1257-1273.
40. Lintner, J. (1975). Inflation and Security Returns. The Journal of Finance 30(2), pp.259-280.
41. Mankiw, N. G. (2007). Macroeconomics, 6th ed. New York: Worth Publishers.
42. Marshall, A. (1907). Principles of Economics, 5th ed. London: MacMillan.
43. McCulloch, J. H. & Kochin, L. A. (2000). The Inflation Premium Implicit in the US Real and Nominal Term Structures of Interest Rates. Ohio State University Working Paper.
44. Modigliani, F. & Cohn, A. F. (1979). Inflation, Rational Evaluation and the Market. Financial Analyst Journal 35 (2), pp.24-44.
45. Noussair, C., Richter, G. & Tyran, J. (2008). Money Illusion and Nominal Inertia in Asset Markets. No 08-29, Discussion Papers from University of Copenhagen. Department of Economics, doi.org/10.2139/ssrn.1307717
46. Rhodes, J. R. (2008). Evolution of the Fisher equation: Rational Appreciation to Money Illusion, GRIPS Policy Information Center, Discussion Paper 08-04.
47. Ritter, J. R. & Warr, R. S. (2002). The Decline of Inflation and the Bull Market of 1982–1999. Journal of Financial and Quantitative Analysis 37(1) pp. 29–61.
48. Rutledge, J. (1977). Irving Fisher and Autoregressive Expectations, American Economic Review. 67 (1), pp. 200-205.
49. Sarte, Pierre-Daniel, G. (1998). Fisher´s Equation and the Inflation Risk Premium in a Simple Endowment Economy. Federal Reserve Bank of Richmond Economic Quarterly 84, no. 4, pp. 53-72.
50. Schmeling, M. & Schrimpf, A. (2008). Expected Inflation, Expected Stock Returns, and Money Illusion: What Can We Learn from Survey Expectations? SFB 649 Discussion Paper 2008-036. Available at SSRN: http://ssrn.com/abstract=1137898
51. Shafir, E., Diamond, P. & Tversky, A. (1997). Money Illusion, The Quarterly Journal of Economics, 112 (2), pp. 341-374, /doi.org/10.1162/003355397555208
52. Schwert, G. & Fama, F. (1977). Asset returns and inflation, Journal of Financial Economics. 5 (2), pp. 115-146.
53. Svedsäter, H., Gamble, A. & Gärling, T. (2007). Money illusion in intuitive financial judgments: Influences of nominal representation of share prices. Journal of Socio-Economics, 36, 698-712.
54. Thaler, R. H. (1997). Irving Fischer: Modern Behavioral Economist. The American Economic Review, 87(2), pp.439-441.
55. Vaona, A. (2013). Money illusion and the long-run Phillips curve in staggered wage-setting models, Research in Economics, 67 (1), pp. 88–99.
56. Yeh, C. & Chi, C. (2009). The Co-Movement and Long-Run Relationship between Inflation and Stock Returns: Evidence from 12 OECD Countries. Journal of Economics and Management, 5(2), pp. 167-186.
2. Agell, J. & Lundborg, P. (2003). Survey Evidence on Wage Rigidity and Unemployment: Sweden in the 1990s. The Scandinavian Journal of Economics, 105 (1), pp. 15–30, doi.org/10.1111/1467-9442.00002
3. Basak, S. & Yan, H. (2010). Equilibrium Asset Prices and Investor Behavior in the Presence of Money Illusion, Review of Economic Studies, 77 (3): 914-936, doi.org/10.2139/ssrn.623561
4. Basu, S., Markov, S. & Shivakumar, L. (2010). Inflation, Earnings Forecasts, and post-Earnings Announcement Drift. Review of Accounting Studies, 15(2), pp. 403–440, doi.org/10.1007/s11142-009-9112-9
5. Bewley, T. F. (1999). Why Wages Don’t Fall During a Recession. Cambridge MA USA: Harvard University Press.
6. Bittschi, B. & Duppel, S. (2015). Did the introduction of the euro lead to money illusion? Empirical evidence from Germany. ZEW Discussion Papers No. 15-058, ZEW - ZentrumfürEuropäischeWirtschaftsforschung / Center for European Economic Research, https://doi.org/10.2139/ssrn.2661471
7. Blinder, A. (1995). On sticky prices: academic theories meet the real world. in N. G. Mankin (ed) Monetary Policy, Studies in Business Cycles, Vol 28, Chicago and London,University of Chicago Press.
8. Boudoukh, J. & Richardson, M. (1993). Stock Returns and Inflation: A Long-Horizon Perspective. American Economic Review, 83 (5), pp. 1346-55.
9. Brunnermeier, K. M. & Julliard, C. (2008). The Causes and Consequences of Recent Financial Market Bubbles. The Review of Financial Studies, 21(1), pp. 135-180, https://doi.org/10.3386/w12810
10. Campbell, J. & Vuolteenaho, T. (2004). Bad Beta, Good Beta. American Economic Review, 94(5), pp. 1249-1275.
11. Cannon, E. & Cipriani, G. (2006). ‘Euro-Illusion: a Natural Experiment. Journal of Money, Credit and Banking, 38 (5)., pp. 1391 – 1403.
12. Chen, C., Lung, P. P. & Wang, F. A. (2009). Stock Market Mispricing: Money Illusion or Resale Option. The Journal of Financial and Quantitative Analysis, 44 (5), pp. 1125-1147.
13. Cohen, R. B., Polk, C. & Vuolteenaho, T. (2005). Money Illusion in the Stock Market: The Modigliani-Cohn Hypothesis. The Quarterly Journal of Economics, 120(2), pp.639-668, doi.org/10.3386/w11018
14. Cohn, R. A. & Lessard, D. R. (1980). The Effect of Inflation on Stock Prices: International Evidence. WP No.11470 of University of Illinois at Chicago Circle and Massachusetts Institute of Technology presented at the September 1980 meetings of the American Economic and American Finance Associations in Denver, Colorado.
15. Chordia, C. & Shivakumar, L. (2005). Inflation Illusion and Post-Earnings-Announcement Drift. Journal of Accounting Research. 43(4), pp. 521-556.
16. Chytilova, H. (2018). Economic Literacy and Money Illusion, An Experimental Perspective, Routledge, ISBN 9780367594893.
17. Dimand, R.W. (1993). The Dance of the Dollar, Irving Fisher’s Monetary Theory of Economic Fluctuations, History of Economics Review, 20 (1), pp.161-172.
18. Engsted, T. & Pedersen, T. Q. (2016). The predictive power of dividend yields for future inflation: Money illusion or rational causes? CREATES Research Papers 2016-11, Department of Economics and Business Economics, Aarhus University, doi.org/10.2139/ssrn.3233425
19. Fama, E. F. (1976). Inflation Uncertainty and Expected Returns on Treasury Bills. Journal of Political Economy 84, no. 3, pp. 427-48.
20. Fama, E. F. (1975). Short-Term Interest Rates as Predictors of Inflation. American Economic Review 65, no. 3, pp. 269-82.
21. Fama, F. (1981). Stock Returns, Real Activity, Inflation, and Money, The American Economic Review, 71 (4), pp. 545-565.
22. Fehr, E. & Tyran, J. (2001). Does Money Illusion Matter? American Economic Review, American Economic Association, 91(5), pp.1239-1262, December, doi.org/10.1257/aer.91.5.1239
23. Fehr, E. & Tyran, J. (2005). “Expectations and the Effects of Money Illusion” In: Agarwal B. & Vercelli A. (Eds.): Psychology, Rationality and Economic Behavior. Challenging Standard Assumptions. International Economic Association, Ch. 8: pp.155-80, doi.org/10.1057/9780230522343_8
24. Fehr, E. & Tyran, J. (2007). Money Illusion and Coordination Failure, Games and Economic Behavior, Elsevier, vol. 58(2), pp. 246-268, February, doi.org/10.1016/j.geb.2006.04.005
25. Fehr, E. & Tyran, J. (2008). Limited Rationality and Strategic Interaction: The Impact of the Strategic Environment on Nominal Inertia, Econometrica, Econometric Society, vol. 76(2), pp.353-394, 03, doi.org/10.2139/ssrn.354580
26. Feldstein, M. (1980). Inflation and the Stock Market. American Economic Review 70(5), pp.839-847.
27. Fisher, I. (1896). Appreciation and Interest. Publication of the American Economic Association. 3rd series XI. 4, Reprinted Fairfield, NJ:Kelley, A. M. (1991).
28. Fisher, I. (1906). The Nature of Capital and Income. New York: Macmillan.
29. Fisher, I. (1913). A Compensated Dollar, The Quarterly Journal of Economics, vol.27, No.2, pp. 213-235.
30. Fisher, I. (1928). The Money Illusion, New York: Adelphi Publishers.
31. Fisher, I. (1930). The Theory of Interest, London: Macmillan.
32. Fortin, P. (2013). The Macroeconomics of Downward Nominal Wage Rigidity: A Review of the Issues and New Evidence for Canada. Cahiers de recherche WP No. 1309. Available at: http://www.cirpee.org/fileadmin/documents/Cahiers_2013/CIRPEE13-09.pdf
33. Gavriilidis, K. & Kgari, L. M. (2016). Stock Returns and Inflation, the Case of Botswana. Handbook of Frontier Markets. The European and African Evidence, pp. 27-38.
34. Gultekin, B. N. (1983). Stock Market Returns and Inflation: Evidence from Other Countries. The Journal of Finance, 38, (1), pp. 49-65.
35. Hirschleifer, J. (1970). Investment, Interest, and Capital. Englewood Cliffs, N.J.: Prentice-Hall.
36. Hogan, S. (2013). What Does Downward Nominal-Wage Rigidity Imply for Monetary Policy? Bank of Canada WP No.97-13, Bank of Canada. Available at: http://publications.gc.ca/collections/Collection/FB3-2-97-13E.pdf
37. Jureviciene, D. & Markelova, J. (2016). Assessment Of Money Illusion Impact On Individuals’ Economic Behaviour In Lithuania. European Scientific Journal, ESJ, 12(13), 1. https://doi.org/10.19044/esj.2016.v12n13p1
38. King, R. G. & Watson, M. W. (1997). Testing Long-run Neutrality," Economic Quarterly, Federal Reserve Bank of Richmond, 83(3), pp. 69-101.
39. Lee, B. S. (2010). Stock returns and inflation revisited: An Evaluation of the Inflation Illusion Hypothesis, Journal of Banking & Finance, 34 (6), pp. 1257-1273.
40. Lintner, J. (1975). Inflation and Security Returns. The Journal of Finance 30(2), pp.259-280.
41. Mankiw, N. G. (2007). Macroeconomics, 6th ed. New York: Worth Publishers.
42. Marshall, A. (1907). Principles of Economics, 5th ed. London: MacMillan.
43. McCulloch, J. H. & Kochin, L. A. (2000). The Inflation Premium Implicit in the US Real and Nominal Term Structures of Interest Rates. Ohio State University Working Paper.
44. Modigliani, F. & Cohn, A. F. (1979). Inflation, Rational Evaluation and the Market. Financial Analyst Journal 35 (2), pp.24-44.
45. Noussair, C., Richter, G. & Tyran, J. (2008). Money Illusion and Nominal Inertia in Asset Markets. No 08-29, Discussion Papers from University of Copenhagen. Department of Economics, doi.org/10.2139/ssrn.1307717
46. Rhodes, J. R. (2008). Evolution of the Fisher equation: Rational Appreciation to Money Illusion, GRIPS Policy Information Center, Discussion Paper 08-04.
47. Ritter, J. R. & Warr, R. S. (2002). The Decline of Inflation and the Bull Market of 1982–1999. Journal of Financial and Quantitative Analysis 37(1) pp. 29–61.
48. Rutledge, J. (1977). Irving Fisher and Autoregressive Expectations, American Economic Review. 67 (1), pp. 200-205.
49. Sarte, Pierre-Daniel, G. (1998). Fisher´s Equation and the Inflation Risk Premium in a Simple Endowment Economy. Federal Reserve Bank of Richmond Economic Quarterly 84, no. 4, pp. 53-72.
50. Schmeling, M. & Schrimpf, A. (2008). Expected Inflation, Expected Stock Returns, and Money Illusion: What Can We Learn from Survey Expectations? SFB 649 Discussion Paper 2008-036. Available at SSRN: http://ssrn.com/abstract=1137898
51. Shafir, E., Diamond, P. & Tversky, A. (1997). Money Illusion, The Quarterly Journal of Economics, 112 (2), pp. 341-374, /doi.org/10.1162/003355397555208
52. Schwert, G. & Fama, F. (1977). Asset returns and inflation, Journal of Financial Economics. 5 (2), pp. 115-146.
53. Svedsäter, H., Gamble, A. & Gärling, T. (2007). Money illusion in intuitive financial judgments: Influences of nominal representation of share prices. Journal of Socio-Economics, 36, 698-712.
54. Thaler, R. H. (1997). Irving Fischer: Modern Behavioral Economist. The American Economic Review, 87(2), pp.439-441.
55. Vaona, A. (2013). Money illusion and the long-run Phillips curve in staggered wage-setting models, Research in Economics, 67 (1), pp. 88–99.
56. Yeh, C. & Chi, C. (2009). The Co-Movement and Long-Run Relationship between Inflation and Stock Returns: Evidence from 12 OECD Countries. Journal of Economics and Management, 5(2), pp. 167-186.
Published
2022-05-31
How to Cite
Chytilova, H. (2022). Fisher Equation and Modigliani-Cohn Hypothesis in the Financial Markets. European Scientific Journal, ESJ, 18(15), 56. https://doi.org/10.19044/esj.2022.v18n15p56
Section
ESJ Social Sciences
Copyright (c) 2022 Helena Chytilova
This work is licensed under a Creative Commons Attribution-NonCommercial-NoDerivatives 4.0 International License.
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