2.1 Introduction

This chapter focuses on the literature review aspect of this study. It reviews issues around inflation and stock returns.

2.2.1 Conceptual Issues

Inflation has defined in many ways by different economist. According to Johnson, 1972, inflation is simply defined as sustained rise in general price level. Inflation is usually measured over periods that are sufficiently long to eliminate any bias arising from short term phenomena. Inflation is now worldwide, and it is one of the greatest challenges facing most nations in the 1980s. One significant feature of the present inflationary trend is its ability to defy solution in most countries (Ajayi and Ojo, 2006).

2.2.2 Sources of Inflationary Pressures

One of the major challenges facing economists today is the re-examination and classification of their views on the forces that produce large variations in price level. There has been in the last few years an abundance of literature on the subject of inflation (Ajayi and Ojo, 2006).

According to Ajayi and Tariba 1974, there are three major categories of causes. Namely;

• The monetarist explanation of inflation
• Cost push theories of inflation; and
• Excess demand theories of inflation

The monetarist explanation of inflation

The monetarists view inflation exclusively in terms of increases in the money supply. The monetarist explanation is build up from the quantity theory of money. The quantity theory based on the contribution of prominent economist like Irvin fisher, Alfred marshall, A.C. Pigou and Keynes in the early decades of the twentieth century. The fisher’s equation of exchange, the Cambridge equation and the Chicago school of monetarists are major contribution of these economists. In recent years, there has been a resurgence of the quantity theory in what is known as monetarism, the most well-known advocate being Milton Friedman of the University of Chicago. The monetarists assert that the significant determinant aggregate spending is the supply of money. Hence, increases in the money supply are seen the important causes of inflation.

Cost Push theories of inflation

According to this view, the studies of institutional framework within which prices and wages are determined are vital when understanding inflationary process. The role of the trade union in securing increased wages is emphasized because it leads to increase in money value of national income and inflation. The trade unions use the threat of an all out strike to pressurize government and other employers of labour to increase their wages. This increase may lead to increase in cost of production which is passed on to the final consumers of goods and service in the form of higher prices. However, this cannot occur in a perfectly competitive market where labor unions cannot exercise tight control over the supply of labour and the substitution between labour and other factors of production are perfect in economic sense. The profit push inflation can also be seen as another version of cost push inflation. This is when firms maintain certain profit margin or mark-up which might become an important element in the inflationary process.

Excess Demand Theories

Excess demand is when the supply of goods and services falls short of the demand for them. Excess demand leads to rise in prices of goods and services because interested consumers engage in competitive bidding which result into higher prices. This view is better explained using the Keynesian analysis.

2.2.3 Effects of Inflation

Developing countries experiencing growth usually have some form of inflation. Some economists have argued that some form of inflation is inevitable for growth. The history of inflation has many instances of countries that have inflation without growth and others that have growth without inflation (Friedman, 1973).

Hinshaw (ed.) (1972) opined that inflation is an evil that should be avoided; suggest the following as the reason for this.

Firstly, inflation impairs the usefulness of money, and some cases it destroys its usefulness completely when the rate is too high. When this occur, contracts expressed in monetary term and goods and services that can be bought with a unit of money falls.

Secondly, inflation hinders effective distribution of income and wealth. Inflation has pervasive effect on the income of workers with fixed wages such as salary earners, pensioners and those whose income depend heavily on fixed-income assets like bonds. The present of inflation makes borrowers to gain while lenders loss. Since at the time when the borrower wants to repay his loan, the value of the exact amount would have being reduced because of inflation.

Thirdly, inflation may lead to balance of payment crisis. With inflation competitiveness and contraction of sales are weakened because of the upward pressure on prices and costs. Therefore, people would prefer to sell their goods in an economy with high inflationary rate than to buy in that economy.

Finally, the performance of an economy is distorted and destabilized because people are encouraged to accumulate inventories speculatively; there is also the issue of misallocation of resources and depressing effect on output and employment due to excessive bidding for real capital assets like land. However, as argued by many economists, inflation can serve as a catalyst for effective economic development since it may favour capital investment and thus increase the growth of potential output.

2.2.4 Stock Returns

Stock return may be defined as a measure of the return that a firm’s management is able to earn on common stockholders’ investment. Return on common stock equity is calculated by dividing the net income minus preferred dividends by the owners’ equity minus the par value of any preferred stock outstanding. For firms with no preferred stock, return on common stock equity is identical to return on equity. The American Heritage® Dictionary of Business Terms Copyright © 2010

2.2.5 Determinants of Stock Returns

Stock returns are volatile overtime. According to Emenike, 2010, Volatility clustering occurs when large stock price changes are followed by large price change, of either sign, and small price changes are followed by periods of small price changes. However, Robert and Nardin (1996) suggested that there is possibility for the determinants of differential stock returns to be stable over time, and the forecasting power of the expected return factor model may also be high. Interestingly, they also found out that there seems to be a great deal of commonality across markets in firm characteristics that explain differences in expected returns. This is true in spite of the fact that the monthly “payoffs” to these characteristics are not significantly correlated across the five countries examined. Thus, the determinants of expected stock returns appear to be com