A Theory of the Nominal Character of Stock Securities

Abstract

Abstract We construct recursive solutions for, and study the properties of the dynamic equilibrium of an economy with three types of agents: (i) household/investors who supply labor with a finite elasticity, consume a large variety of goods that are not perfect substitutes and trade government bonds; (ii) firms that produce those varieties of goods, receive productivity shocks and set prices in a Calvo manner; (iii) a government that collects an income-driven fiscal surplus and acts mechanically, buying and selling bonds in accordance with a Taylor policy rule based on expected inflation. In this setting, we show that stock market returns are much less than one-for-one related to inflation over a 1-year holding period, which means that stock securities have a strong nominal character. We also show that their nominal character diminishes as the length of the stock-holding period increases, in accordance with empirical evidence.