Price Dividend Models Revisited, and their Role as Indicators for Monetary Policy

This paper investigates the role of inflation risk in a model of the price dividend ratio, combining a dynamic Gordon model specification with the inflation-augmented capital asset pricing model (CAPM). The model is estimated for the Euro Area and U.S. and tested against traditional models. For the Euro Area, results are in line with the data and with earlier models, while for the U.S., there are discrepancies, suggesting the model may be useful to explain the bubble in the U.S. stock market. In a next stage, aggregate demand and supply equations are estimated and the additional value of price dividend metrics is investigated using robust regression techniques. The evidence suggests that model metrics are useful signals of the output gap and inflation. Finally, for the U.S., the overvaluation of the price dividend ratio, derived from the proposed model, seems to have had an impact on the Fed(TM)s interest rate policy.