The effects of stochastic inflation on equity prices and the equity premium are studied in a pure-endowment asset-pricing model with a cash-in-advance constraint. Stochastic inflation affects the equity premium through two channels: the assessment of an inflation tax and the presence of an inflation premium. Real and monetary versions of the model are simulated and the comparative dynamic results corroborate the conclusion that inflation has quantitatively important effects.
The other important result is that the equity premium in the real version of a model—a continuous state-space generalization of Mehra and Prescott (1985)—and the monetary model is very sensitive to the conditional variance of endowment growth. When the standard deviation of endowment growth is increased from 3.49 percent (the estimated value) to 5.59 percent, the real model can generate an equity premium of 2.8 percent in the range of the risk aversion parameters considered by Mehra and Prescott. The monetary model displays similar sensitivity and can generate an equity premium of 5.81 percent.