Stock prices and inflation: relationship revisited

Abstract. This study examines the nature of relationship between inflation and stock price movement. The analytical literature mentions the possibility of a negative and a positive relationship both. Using the VAR framework based on monthly data for wholesale price index, index of industrial production, exchange rate, stock prices and foreign institutional investment we note that stock prices have an impact on inflation whereas the causality in the reverse direction is not prominent. The results from the impulse response function tend to suggest that the nature of relationship is rather negative. When stock prices are low the firms are reluctant to tap the capital market. Unless bank finance can substitute adequately for the capital market firm’s investment plans would be hit and production would decline. This may result in a price rise as the market demand may exceed the supply. An important policy implication is augmentation of production by encouraging invest-ment through inexpensive bank finance. However in the very long run as we observe from the co-integrating equation, inflation influences stock prices and that too in a positive direction. Unexpected inflation raises the firm’s equity value if they are net debtor. Similarly tightening of monetary policy can reduce inflation and stock prices both as individuals will be left with less money to buy goods or buy stocks