Does the Indonesian Stock Market Provide a Good Hedge Against Inflation? Evidence from the Pre-1997 Financial Turmoil

Abstract

This study explores the relationship between real stock returns and inflationary trends in the Indonesian economy during the pre-1997 financial crisis period. It attempts to test the relationship between real stock returns and inflation in the light of: (i) the Fisher hypothesis that asserts the independence of real stock returns and inflation, and (ii) Fama?s (1981) proxy effect framework which states that the negative real stock returns-inflation is indirectly explained by a negative real economic activity-inflation and a positive real stock returns-real economic activity relationship. A negative relationship between real stock-returns and inflationary trends is recorded. This finding is contradictory with the Fisher hypothesis which implies that the Indonesian stock market does not provide a good hedge against inflation. Fama's proxy hypothesis was found unable to explain in its entirety the negative relationship between real stock returns and inflation in the Indonesian stock market. A positive relationship between real economic activity and inflation, and a negative relationship between real stock returns and real economic activity were recorded. This result shows a consistency with the Mundell-Tobin hypothesis.