Stock prices, inflation, and output in India: An empirical analysis

• Author: Arjun Vadivel,Chandrashekar Raghutla,Thokala Sampath
• DOI: http://doi.org/10.1002/pa.2052
• Date: 01 August 2020
• Published date: 01 August 2020

ACADEMIC PAPER

Stock prices, inflation, and output in India: An empirical

analysis

Chandrashekar Raghutla

1

| Thokala Sampath

2

| Arjun Vadivel

3

1

Department of Economics, Central University

of Tamil Nadu, Thiruvarur, India

2

Department of Applied Economics, Telangana

University, Telangana, India

3

Department of Economics, Arignar Anna

Government Arts and Science College,

Karaikal, Karaikal, India

Correspondence

Chandrashekar Raghutla, Department of

Economics, Central University of Tamil Nadu,

Thiruvarur, India.

Email: chandrashekareco@gmail.com

This study focusses on the negative relationship between inflation and stock returns

(the puzzle of fisher hypothesis). Fama hypothesis examined the relationship

between macroeconomic variable and stock return and found the strong relationship

between the real output and stock prices. This study revisits Fama's hypothesis from

the period 1990M1 to 2016M6 for emerging country perspective. The results docu-

mented that there is a significant negative relationship between inflation and output

whereas positive between stock price and output.

1|INTRODUCTION

1.1 |Background

According to Fama's (1981) hypothesis, inflation was negatively

related with output and stock prices were positively related with out-

put. This idea was loosely based on the Fisher (1930) hypothesis that

stock market returns are independent of inflationary expectations.

The popular Fisherian hypothesis shows real returns as a function of

expected inflation whereas nominal returns to be a function of unex-

pected inflation. There are similar studies, such as Bodie (1976), Peel

and Pope (1988), and Li, Narayan, and Zheng (2010). Fama (1981)

highlighted that there is a positive and negative relationship between

stock returns, inflation, and their impact on real output. First, this

empirical study tests two hypotheses, a positive association between

real stock returns and real output. Second, there is a negative relation-

ship between real output and inflation.

However, over the last few decades, several studies have exam-

ined the dynamic relationship among stock prices, inflation, and out-

put growth in the stock returns and inflation. Large part of literature

has empirically verified negative association between inflation and

stock returns (Adams, McQueen, & Wood, 2004; Bodie, 1976; Fama,

1981). On the other hand, several studies showed positive relation-

ship between stock prices and output (Fama, 1981; Chatrath et al.,

1996; Durai & Bhaduri, 2009).

There are numerous studies that have used the U.S. and

European countries' data, which consistently rejected the Fisherian

hypothesis (Asprem, 1989; Fama, 1981; Geske & Roll, 1983; Lintner,

1975). Those studies have explored negative and significant relation-

ship between the real stock returns and inflation and failed to justify

this paradoxical relationship as an alternative. This paradox in financial

literature is assembled as “stock return–inflation puzzle.”This puzzle

has been explored as emerging economies.

Chatrath, Sanjay, and Song (1996) examined the relationship

among stock returns, inflation, and output for India. It is evident

from their study that there is partial support for Fama hypothesis

and also indicated a negative relationship between stock returns

and inflation for unexpected component of inflation. As a perfect

hedge, when the expected inflation and stock returns are nega-

tively related. It has significantly understood the relationship

between output stock prices and rate of inflation for a better

outlook.

1.2 |Motivation

The objective of this study is to analyse Indian stock prices, inflation,

and output nexus. There are two facts. First, there is lack of empirical

as well as theoretical consensus on linkages between stock prices,

inflation, and output. Hence, examining this empirical relationship

through extended datasets can provide new and significant insights.

Towards this end, the present study uses both updated and extended

datasets compared with the extent literature of India.

Second, there are few studies in India, such as Chatrath et al.

(1996) and Durai and Bhaduri (2009). The main aim of this study is to

Received: 19 October 2019 Accepted: 31 October 2019

DOI: 10.1002/pa.2052

J Public Affairs. 2019;e2052. wileyonlinelibrary.com/journal/pa © 2019 John Wiley & Sons, Ltd. 1of5

https://doi.org/10.1002/pa.2052

J Public Affairs. 2020;20:e2052. wileyonlinelibrary.com/journal/pa © 2019 John Wiley & Sons, Ltd. 1 of 5

https://doi.org/10.1002/pa.2052