Abstract
This empirical study examines the relation between the equity premium – the difference between the expected stock and risk-free return – and inflation in the major economies in the post-Bretton Woods era. We estimate a country-average level of the equity premium between 0.8% and 2%, confirming a shrinking premium. Regressions and impulse responses show that the equity premium significantly positively adjusts to inflation. Inflation is thus essential in explaining the level of the equity premium and provides a partial resolution to the equity premium puzzle.
Notes
1It is important to note that their expected equity return and resulting equity premium are unconditional. This approach only holds when the dividend yield and the price/earnings ration are mean-reverting. Formal unit roost tests indeed indicate that both metrics are stationary.
2A similar decline in the equity premium is observed for Fama and French (Citation2002) average return and dividend growth models. These results are available upon request.
Table 1. ERP estimates by decade in the post-Bretton Woods era
3A reversed ordering of the variables in the system does not alter the results.
Fig. 1 Adjustment of the equity premium to an unexpected temporary shock in inflation
