Inflation and the Valuation of Corporate Equities

Lawrence H. Summers

NBER Working Paper No. 824
Issued in December 1981
NBER Program(s):Public Economics

This paper examines the relationship between inflation and the return on individual corporate securities. This question is of substantial importance in light of the puzzling behavior of the stock market over the last decade. Conventional financial theory holds that equity should be a good inflation hedge since it represents a claim of real rather than nominal assets. Yet a negative relationship between both expected and unexpected inflation and stock market returns has been widely documented. This relationship, which appears to antedate the surge in inflation over the last 15 years. might provide an explanation for the market's surprising recent performance. This paper studies differences across firms in the response of stock market values to changes in expected inflation in an effort to explore the reasons for the aggregate negative relationship between inflation and stock market values. Two opposing hypotheses about the impact of inflation on market valuation are contrasted. The "inflation illusion" hypothesis holds that investors are not able to see through nominal accounting statements and respond to reported rather than real profits. The opposing "tax effects" hypothesis holds that firms which report spuriously high profits due to inflation are penalized because the extra tax burden incurred reduces real profits. The results from the 1970's strongly bear out the predictions of the tax effects hypothesis. Aggregate calculations suggest that the interaction of inflation and taxation can account for a large part of the decline in the stock market which has been observed over the past decade. A significant part of the remainder appears to be due to increasing investor awareness of the need to adjust for historic cost depreciation.

download in pdf format
   (538 K)

download in djvu format
   (395 K)

email paper

Machine-readable bibliographic record - MARC, RIS, BibTeX

Document Object Identifier (DOI): 10.3386/w0824

Published: (With M.Feldstein) Published as "Inflation and the Taxation of Capital Income in the Corporate Sector", NTJ, Vol. 32, no. 4 (1979): 445-470.

Users who downloaded this paper also downloaded* these:
Feldstein Inflation and the Stock Market
Campbell and Vuolteenaho w10263 Inflation Illusion and Stock Prices
Feldstein w0276 Inflation and the Stock Market
Pearce and Roley w2366 Firm Characteristics, Unanticipated Inflation, and Stock Returns
Summers w0604 Inflation, Taxation, and Corporate Investment: A q-Theory Approach
NBER Videos

National Bureau of Economic Research, 1050 Massachusetts Ave., Cambridge, MA 02138; 617-868-3900; email:

Contact Us