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Literature review: 1. Introduction:  The interaction between stock returns, inflation and monetary policy is an area that has interested monetary and financial economists for a long time. My project will focus on how inflation and interest rate impact on stock market. And this literature review will go back over different opinions on the relationship between stock returns, inflation and interest rates and attempt to find out what and why they have such complicated relationship.  2. Definition of inflation:   Inflation is a common phenomenon that the prices of goods and services are increasing, whereas the value of pounds is decreasing.  Retail price index (RPI) and consumer price index (CPI) both are basic approaches to measure the rate of inflation in the England. Nellis.J G&Parker.D, (2004) 3. Causes of inflation: There are two major causes for the occurrence of inflation. The first cause is the so-called demand-pull force and the other is called cost-push force. ‘Demand-pull inflation occurs when the aggregate demand increasing however aggregate supply fails to match it, forcing price increases and pulling up wages, materials, and operating and financing costs. Cost-push inflation occurs when prices rise to cover total expenses and preserve profit margins’. (The official CIMA learning system, CIMA business) 4. Policies deal with inflation: Three primarily policies are introduced to deal with different causes of inflation:  1. Monetary Policy: the monetary policy focus on the changes of interest rates to control inflation. The central bank of England sets a central inflation target, when the inflation rate fluctuate more than 1% around 2%, the interest rates will be changed to balance it. 2. Fiscal Policy: the government prefers to reduce The Assignment is provided by UK Assignment it is expenditures to less budget deficit or increase it is income by increase tax revenue to erode inflation. 3. “Prices and incomes Policy: prices and incomes policies tackle inflation by influencing cost factors and especially wage rates.” (Nellis.J G&Parker.D) 4. Effects of inflation: The effects of inflation are stated in the text book is “Distorts consumer behavior, Redistributes wealth, Redistributes incomes, Affects wage bargainers, Undermines business confidence, and weakens the external competitive position.” (The official CIMA learning system, CIMA business) 5. Previous literature reviews----------interest rate and stock return Jensen and Mercer (2002) utilized metering method to analyze how discount rates affect on stock prices. He indicated that the unexpected interest rate changes can strongly stimulate the stock market, while the stock prices are hardly respond to expected interest rates as quickly as unexpected interest rates. So it is very important for us to identify and distinguish the unexpected and expected interest rates when researching the relationship. Fama (1990) studied the American market and revealed that in American stock market, stock prices had the long-term balance relation with interest rates. Mukherjee and Naka (1995), Maysam and Koh (2000) studied Japanese stock market and Singapore stock market in respectively, and worked out a similar conclusion with Fama that there was the long-term stable relation between stock prices and interest rates. Rahmn and Mutafa (1997) analyzed the cause-and-effect relationship between stock prices and interest rates in many countries; they came out a result that there might be a significant long run co-integration relationship. Neri (2001) believes that the changes on monetary policy were positively related to the fluctuation of stock prices because of liquidity effect. Speaking more specifically, monetary policies affectThe  Assignment is provided by UK Assignment on the ability of money liquidity, as we all know, funds liquidity is a pivotal factor in the stock market. Therefore, he confirmed that monetary policy, such as interest rate changes plays a pivotal role in influencing on stock returns. Bernanke (1992) believe that in various monetary policy tools, interest rates adjustment had the most significantly influence on stock market. Campbell and Kyle (1988) believe that the monetary policy change resulted in interest rate changes, and it affected stock prices running through the expectation of stock dividends and the estimation of discount rate. 6. Previous literature reviews----inflation and stock return The relationship between inflation and stock return always is a heated and controversial topic in macroeconomics and financial disciplines. Reviewing previous articles in this area, there are three plausible primarily opinions on the relationship between inflation and stock returns: positive correlation, negative correlation and uncorrelated relationship.  Barnes M. and Boyd J.H. and Smith.B.D. (1999) investigated and analyzed several countries data about inflation and stock prices and made a conclusion that under low level inflation or moderate inflation, inflation and nominal equity returns are negatively correlated or even uncorrelated. However, they also agree that inflation and nominal returns have a strongly positive relationship in a high inflation economic circumstance. He thinks that the strengths of inflation determine the relationship between inflation and stock returns. In the next, this essay will attempt to review others’ opinions on the relationship.  Fisher (1930) posed a hypothesis which suggests that stock returns should have a positive relationship with an expectable inflation in an efficient market. In other words, Fisher believes that when the interest rates, discount rates, and inflation rates are expected, a higher inflation can cause a higher stock price. He is one of economists who mainly support the positive relationship. As we all known, inflation can be definite as a process of eroding in the purchasing power of money. Based on Fisher’s hypothesis, a considerable number of scholars think that purchasing shares as a hedging tool that can be used to against inflation, because a higher inflation rate always predict a higher stock return. ‘Broadly selected common stocks are considered to be a good hedge against inflation in the long run’ Cagan (1974) who agrees with the Fisher on the relationship.  Moreover, Boundoukh.J and Richardson.M (1993) tested Fisher’s hypothesis and found that during a long periods the positive relationship between inflation and stock prices is exists.  Furthermore, to examine the relationship, a new approach-------wavelet multiscaling method was invented by Kim. S & In. F (2005) in few years ago. They presented that ‘there is a positive relationship at the shortest scale 1 month period and at the longest scale 128-month period, while a negative relationship is shown at the intermediate scales.’ On the one hand, he confirmed Fisher’s hypothesis, on the other hand, he also suggested that the relationship between inflation and stock prices should be considered within a more or less periods. Hasan. M.S, (1995) attempted to analyses the relationship in the UK, using a range of relative methodologies, such as regression results, VEC model. The result is also accordance with the Fisher’s view. However, in the article, he also compared and explained some different views by other economists who claim inflation and stock prices have a negative relationship. With different views, several classic articles include Nelson (1976), Fama and Schwert (1977), Jaffe and Mandelker (1976) suggested an inverse relationship between inflation and stock returns. Various discussions of the negative relationship have been offered.  Fama (l977) who is an American economist on behalf of the negative The Assignment is provided by UK Assignment correlation between inflation and stock returns created two assumptions: the money supply was exogenous and kept stable; people’s expectation was rational. And according to the quantity theory of money MV = PY, in the process of inflation, because M was stable, it is clear that real economy (presented as Y) would decline, and because the whole economy downturn, the prospect of the economy looked gloomy and less optimist. Therefore, shareholders would sell stocks, and then stock prices fell (Fama EF., 1981).  Many scholars researched the relationship based on Fama’s theory, for instance, Solnik (1983) found that the stock prices of a significant number of countries had a negative correlation with inflation; Gultekin (1983) researched more than seven EU countries’ and American’s information and somewhat supported theory of Fama. These experts made a study on the data after World War Two, almost all of them attempted to prove that during the war periods, especially in American market, the relationship is negative between inflation and stock prices. Sharpe (2002) made a study of Standard & Poor’s Indices 1979-1998 and drew a conclusion that the higher inflation always corresponded to the lower stock prices. Ritter and Warr (2002) inspected the data of US stock market from 1983 to 2000, and came to the conclusion that low inflation rate would be the birth of the stock market bull. Geske and Roll (1983) further developed Fama’s theory; they think that the changes of money supply and money demand are related to the relationship. So they attempted to examine the behaviors of money supplier. They argued that the central bank implemented a counter-cyclical monetary policy caused by the budget deficit, and the policy leading to the negative correlation between stock prices and inflation. Their assumption was that when the real economy was under shock the central bank would adopt the counter-cyclical monetary policy, the analysis approach as follows: the unforeseen fall of stock prices was the signal to anticipate the decline of future economic activities, the decline of future economic output would reduce the government revenues, however people often expected government expenditure unchanged, which would certainly make the investors believe that government would have a financial deficit. Under the circumstances of the fiscal deficit, the government would issue more nominal money, which government action cause the inflation rising, so that leading to the negative correlation between stock prices and inflation. They also surveyed the relationship between US stock prices and inflation after World War Two, and then also conclude a negative relationship. Kaul (1987) stated that money supply and money demand, in realistic, play a decisive role in effecting the relationship. He sets out that money demand and counter-cyclical money supply could explain the negative correlation between postwar stock prices and inflation in the United States. He also pointed out that if money demand is accompanied by the pro-cyclical money supply, then the relationship between stock prices and inflation might be positive. Kaul’s standpoint can be expressed as follows: if real economic growth (downturn) causes the increase (decrease) in money demand, and then money supply goes up (goes down), then it would cause a corresponding rise (decline)The Assignment is provided by UK Assignment  in price of commodities. Therefore, the pro-cyclical monetary policy would give rise to the positive relationship between stock prices and inflation; counter-cyclical monetary policy would lead to the negative relationship.  According to Kaul’s theory, Graham (l996) made an empirical test utilizing US data from l953 to 1990; the results reflect that in different periods the relationship present different features: before 1976 and after 1982, there was negative relevance between stock price and inflation. Between 1976 and 1982, the relationship was positive, which is worth considered that during different periods the relationship can present different natures. I suppose that because various economy conditions and Graham considered the reason is the changes of US monetary policy. At the same time, he also examined how the fiscal deficits effect on the relationship and disagreed with Geske and Roll. 7. Conclusion: Reviewing previous literatures, we can draw a conclusion that there is a close relationship between inflation, interest rate, and stock return, which is also a controversial debate, and interest rate and cash flows are two mainly factors fluctuated by inflation. The government wants less budget deficits by implementing monetary policy which is mainly consisted by interest rate changes; the changes of interest rates as discount rates are used in calculation of stock market. Little researches have been done in discovering how inflation influences on concentrated companies and competitive companies respectively, which is an area that my dissertation focus on.  I suppose that the specific inflation can affect stock returns through changes cash flows; and general inflation through influence on interest rates to affect on stock market. Therefore, specific Inflation can be seen as a double-edges sword impact on companies’ cash flows. On the one hand, it can enhance companies’ cash flows due to higher selling prices. On the other hand, as general goods prices are increased by inflation, the cost of productions getting higher as well. Inflation can induce a broader fierce competition and make companies less profitability due to higher selling prices and higher costs respectively. Therefore, it is worth to consider whether or not specific inflation could really enhance cash flows of companies, and then increase share prices. As concentrated companies who are enough mightiness, powerful and monopolistic in the industrial field, seems always get benefits from inflation, because concentrated companies play a dominant role in the market: the customers have no alternative options to choose and have to accept higher purchasing prices; Moreover, taking advantages of famous brands and economic strengths, the concentrated companies may not be impacted by higher material costs. In contrary, competitive companies have to code with more fierce competitions because customers want to find the lowest price from a general higher prices list. My dissertation on the one hand focuses on how general inflation affects on interest rate and then affect on share prices. On the other hand it will concentrate on how specific inflation influence on concentrated companies and competitive companies respectively.References:     Books： 1. Nellis.J G&Parker.D, (2004), Principles of Macroeconomics, England, Pearson Education Ltd.  2. Fisher, I. (1930). ‘The theory of interest’, New York, Macmillan Co.  3. Paper C04, Fundamentals of Business Economics, Relevant for 2009 Computer-Based Assessments, The Official CIMA Learning System. Journals: articles  1. Barnes.M & Boyd.J.H& Smith.B.D, (1999), Theories of Money: ‘Credit and Aggregate Economic Activity Inßation and asset returns’.pp737-754. 2. Boudoukh, J., Richardson, M., (1993), Stock returns and inflation: ‘a long horizon perspective’. American Economic, pp1346–1355 3. Bernanke, B. & Blinder, A. (1992). The Federal Funds Rate and the Channels of Monetary Transmission. American Economic Review, 82, 901-921. 4. Cagan, P. (1974). ‘National Bureau of Economic Research Annual Supplement Thirteen’: Common stock values and inflation: the historical records of many countries, New York. 5. Campbell, J. Y. & Kyle, A. S. (1988). Smart Money, Noise Trading and Stock Price Behavior. NBER Technical Working Paper 72. 6. Fama, E. F. (1990). Stock returns, expected returns and real activity. Journal of Finance, 45 (4), 1089-1108. 7. Fama, E.F., and O.W. Schwert. 1977. Asset returns and The Assignment is provided by UK Assignment inflation. Journal of Financial Economics 5: 115–46. 8. Fama, E.F. (1981). Stock Returns, Real Activity, Inflation and Money. American Economic Review, 71 (4), 545-565.  9. Gultekin. N.B, (1983), ‘Stock Market Returns and Inflation: Evidence from Other Countries’. The Journal of Finance, Vol38, No.1, PP.49-65 10. Geske, R. & Roll, R. (1983). The monetary and Fiscal Linkage Between Stock Returns and Inflation. Journal of Finance, 38, 1-33. 11. Graham, F. C. (1996). Inflation, Real Stock Returns and Monetary Policy. Applied Financial Economics, 6, 29-30. 12. Hasan. M.S, (1995), The European Journal of Finance: Stock returns: ‘inflation and interest rates in the United Kingdom’ 13. Jaffe, J.F., and G. Mandelker. 1976. The “Fisher effect” for risky assets: an empirical investigation. Journal of Finance 31: 447–58 14. Jensen, G. R. & Mercer, J. M. (2002) Monetary Policy and the Cross-section of Expected Stock Returns. Journal of Fi-nancial Research, 25, 125-139. 15. Kim. S & In. F (2005), The relationship between stock returns and inflation: ‘new evidence from wavelet analysis’, Journal of Empirical Finance, pp435-444 16. Kaul, G. (1987). Stock Returns and Inflation: The Role of the Monetary Sector. Journal of Financial Economics, 18 (6), 253-276. 17. Mukher, T.K. & Naka, A. (1995). Dynamic relations between macroeconomic variables and the Japanese’s stock market: An application of a vector 18. Maysam, I. R. C. & Koh, T. S. (2000). A vector error correction model of the Singapore stock market. International Review of Economics and Finance, 9(1), 79-96. 19. Nelson, C.R. (1976). Inflation and rates of return on common stocks. Journal of Finance 31: 471–83. 20. Neri, F. (2001). Monetary Policy and Stock Prices; Theory and Evidence. Paper for Macro and Finance Research Group Annual Conference held at Queen’s University, Belfast in September.  21. Ritter, J. R. & Warr, R S. (2002). The decline of inflation and the bull market of 1982 to 1999. Journal of Financial and Quantitative Analysis, 37, 29-61. 22. Rahmn, M. & Mutafa, M. (1997). Dynamic Linkages and Grange Causality between short term US corporate bond and stock market. Applied Economics Letters, 4, 89-91. 23. Solnik, B. (1983). The Relation between Stock Prices and Inflationary Expectations: The International Evidence. Journal of Finance, 38, 35-48. 24. Sharpe, S. A. (2002). Reexamining Stock Valuation and Inflation: The Implications of Analysts’ Earnings Forecasts. Review of Economics and Statistics, 84, 632-648  Websites:  http://en.wikipedia.org/wiki/Inflation  accessed on 27/11/2009