ARDL bounds tests and robust inference for the long run relationship between real

stock returns and ination in Australia

Mustabshira Rushdi
a
, Jae H. Kim
b,
, Param Silvapulle
c
a
Department of Marketing, Monash University, Australia
b
Department of Finance, La Trobe Business School, La Trobe University, Australia
c
Department of Econometrics and Business Statistics, Monash University, Australia
a b s t r a c t a r t i c l e i n f o
Article history:
Accepted 29 December 2011
JEL classication:
E31
G1
C12
Keywords:
ARDL bounds tests
Long run relationship
Bias-corrected bootstrap
This paper conducts an empirical investigation into the long run relationship between real stock returns and
ination in Australia by employing the ARDL bounds tests. There exists a stock returnination long run re-
lationship, and the long run parameters are non-linear functions of those of the conditional error correction
model. The OLS estimates of the latter model constitute the long run parameter estimates and their standard
errors are estimated by delta methods. The long run model estimates so constructed can be biassed and in-
consistent, and the delta method is derived assuming asymptotic normality, which does not hold in this in-
vestigation. In this paper, to overcome these limitations of the traditional methods, we employ the bias-
corrected bootstrap method. As a consequence, the robust and reliable statistical inference can be made on
the long run returnination relationship. The empirical results show that the expected ination had no sig-
nicant effect on real stock returns, while the observed ination had a signicant and negative effect. Fur-
thermore, the data generating process of the returnsination relationship was not affected by the change
in monetary policy regime in the early 1990s. These ndings imply that Australian stocks have been very ef-
fective instruments for hedging against expected ination. Because of the resilience of Australian economy to
the current global nancial and economic crisis, this nding has implications for long term domestic and for-
eign investors in Australia.
2012 Elsevier B.V. All rights reserved.
1. Introduction
From the huge empirical literature on the relationship between real
stock returns and ination, it is evident that most of the research has
been largely on the short run relationship using mainly short time
frame and/or short horizon returns. By contrast, only a few studies have
focused on the long run (LR) relationship between the stock returns
and ination series. This paper conducts an empirical investigation into
the LR relationship between real stock returns and expected ination in
Australia. Under the Fisher hypothesis, the expected ination has no ef-
fect on real stock returns, and if so, common stocks can be used as a
hedge against expected ination. Because of the resilience of Australian
economy to the current global nancial and economic crises, the empiri-
cal ndings of this study will have implications for domestic and foreign
investors in making decisions on long terminvestments in Australia. Fur-
ther, the empirical validity of the long run stock returnination relation-
ship has been scrutinised mainly for countries such as USA, UK, G7 and
some emerging economies; see, for example, Boudoukh and Richardson
(1993), Ryan (2006), and Alagidede (2009) and references therein. How-
ever, only a fewattempts have been made to investigate this relationship
in Australia (Crosby, 2001).
The objectives of this paper are to: (i) conduct an empirical inves-
tigation into the long run level relationship between real stock
returns and ination in Australia, using both expected and observed
ination series; (ii) employ ARDL bounds testings proposed by
Pesaran et al. (2001) for the presence of this LR relationship, and to
use the bias-corrected bootstrap method in order to conduct reliable
statistical inference on the LR model parameters; and (iii) examine
the effect of the shift in the Australian monetary policy to ination
targeting in the early 1990s on the LR relationship.
Focusing on long horizon return, several studies (for example,
Alagidede, 2009; Boudoukh and Richardson, 1993; Ryan, 2006 and
Wong and Wu, 2003) document a positive relationship between
nominal stock returns and ination over long horizons. These ndings
are in disagreement with those of studies that employed panel or
cross section data analysis. For example, Barnes et al. (1999) used
the average nominal returns and ination series of 25 countries
over 32 years and found that such LR positive relationship is evident
only in countries with high ination but not in those with a low to
moderate ination environment. Further, Lin (2009) used panel
data of 16 OECD countries and found that anticipated, unanticipated
Economic Modelling 29 (2012) 535543
Corresponding author at: School of Economics and Finance, La Trobe University,
Australia.
E-mail address: j.kim@latrobe.edu.au (J.H. Kim).
0264-9993/$ see front matter 2012 Elsevier B.V. All rights reserved.
doi:10.1016/j.econmod.2011.12.017
Contents lists available at SciVerse ScienceDirect
Economic Modelling
j our nal homepage: www. el sevi er . com/ l ocat e/ ecmod
and ination uncertainty have negative long run effects on real stock
returns.
The past two decades have witnessed the evolution of literature
on the use of cointegration and error correction modelling (ECM)
methodologies developed by Engle and Granger (1987) and
Johansen and Juselius (1990), for establishing LR relationships
among economic and nancial variables. To employ these methodol-
ogies, however, the order of integration of variables is tested rst, and
if they are all I(1), then it is followed by testing for cointegration of
these variables. As is well-known, the presence of cointegration indi-
cates the existence of long run (LR) relationship, which facilitates the
analysis of short run dynamics using ECM. Clearly, application of coin-
tegration and ECM methodologies discussed above depends largely
on the prior information on the time series being I(1), which may
be incorrectly determined by ADF or PP tests, since they suffer from
low size and power properties especially in small to moderate sam-
ples (Enders, 1995). Therefore, these pretesting requirements and
the outcomes can preclude investigating the existence of LR relation-
ship between real stock returns and ination, if both stock returns
and ination are not found to be of the same order I(1).
1
The ARDL bounds testings methodology we adopt in this paper is
attractive, because it does not require pretesting of integration (sta-
tionary or non-stationary) properties of data series, and hence does
not suffer from the limitations we discussed in the previous para-
graph. That is, one can proceed to testing for the presence of long
run level relationship between the series without establishing if the
series are I(1) or I(0). The ARDL bounds testing procedure proposed
by Pesaran et al. (2001) is used for testing the existence of LR rela-
tionship between real stock returns and ination that is implied by
the corresponding conditional error correction model (CECM), also
known as ARDL models (see Section 3 for details). As a result, the
LR parameters are nonlinear functions of those of CECM. The LR pa-
rameter estimates are constructed from the OLS estimates of CECM
parameters. Furthermore, the standard errors of so constructed LR pa-
rameter estimates are usually computed by the delta method. There
are some well-known problems associated with these traditional es-
timation methods: (i) The constructed LR parameter estimators can
be biassed and inconsistent in small to moderate samples; and (ii)
the delta method is derived assuming asymptotic normality of the
error term, and thus this method may be unreliable and non-robust
in small to moderate samples under non-normal error term, which
is often the case in empirical applications. To overcome these limita-
tions, we employ the bias-corrected bootstrap method proposed by
Kilian (1998) to conduct reliable and robust statistical inference on
the LR model parameters. The ARDL and bootstrap methodologies
are briey discussed in Section 3. The use of these methods is not
common in the extant literature
2
on the stock returnination LR re-
lationship. To our knowledge, this is the rst paper to adapt these
methods.
Fama (1981) put forward a proxy hypothesis, which states that in-
ation is a proxy for the real economic activity that affects the real
stock returns, but ination in itself does not have any direct effect
on real stock returns. On the other hand, Geske and Roll (1983) and
Kaul (1987, 1990) emphasised the role of monetary policy on the
stock return ination relationship. To test these hypotheses, several
studies extended the bivariate stock returnination model to a
multivariate setting. We would consider the multivariate model of
real stock returns on ination, real economic activity and monetary
policy and examine if the last two variables play any signicant
roles in determining the returnination relationship; more details
are given in the next section. Another issue investigated in this
paper is the stability of the fundamental relationship between real
stock returns and ination over different monetary policy regimes
that prevailed in the sample period used in this study. Since the
early 1990s, the RBA has adopted an ination targeting policy under
which Australia has been experiencing a low ination environment,
compared with the high inationary regime that prevailed in the
1970s and 1980s.
Using the quarterly data series for the period 1969:2 to 2008:1
and employing the bias-corrected bootstrap method, we found no ev-
idence of the real stock returnexpected ination relationship in the
long run, but a signicant negative long run relationship between
real stock return and observed ination. Moreover, the shift in mon-
etary policy in the early 1990s did not alter the nature of the long
run stock returnsination relationship. These ndings imply that
stocks have been very effective instruments for hedging against
expected ination in Australia.
This paper is organised as follows: the next section describes the
Fisher hypothesis, the bivariate and multivariate models of real
stock returnination relationship. Section 3 briey outlines the
ARDL bounds testing and bias-corrected bootstrap methodologies
for testing various hypotheses and conducting reliable statistical in-
ferences. Section 4 describes the data and the properties of the series
and presents the estimation results. The nal section provides some
concluding remarks.
2. Stock return and ination models
The Fisher equation applied to common stocks can be expressed as
below
nsr
t

e
t

t
1
where nsr
t
is the nominal returns on stocks and
t
is the white noise
error term.
t
e
is the expected ination series E(
t
/
t 1
), where E is
the mathematical expectations operator,
t 1
represents the infor-
mation available at time t 1. Under the Fisher hypothesis, nsr
t
and

t
e
have (11) relationship; in other words, =1.
Assuming that the rational expectation hypothesis is true, the ob-
servedinationseries is commonly usedas a proxy for the expectedina-
tion for testing the validity of Fisher effect. In this paper, we will use both
expected and observed ination series, although the model specications
presented in this section include only the expected ination series (
t
e
).
To obtain the relationship between real stock returns (rsr
t
) and expected
ination
t
e
, substitute the Fisher equation nsr
t
=(rsr
t

t
e
) in model (1)
and obtain the following:
rsr
t

e
t

t
2
where =(1). Now, the Fisher hypothesis is equivalent to =0 in
the above model. In other words, the real stock return is not inuenced
by expected ination
t
e
. The main advantages of working with the real
returns rather than nominal returns are that it allows direct comparison
of ndings of empirical studies on different countries, which may be sub-
ject to different inationary processes (Solnik, 1983). Further, investors
are likely to be more interested in gaining information about their real
returns rather than nominal returns on their investments. A nding of
=0 in Eq. (2) implies that common stocks can be used as a hedge
against the expected ination.
As was discussed in the Introduction, we accommodate the prop-
ositions put forward by Fama (1981), Geske and Roll (1983) and Kaul
(1987,1990) by incorporating the real activity and monetary policy
1
There is a growing body of empirical literature which uses co integration and ECM
methodologies to test for the long run relationship between stock prices and goods
prices (or ination). See for example, Ely and Robinson (1997), Anari and Kolari
(2001), Crosby (2001), Rapach (2002), Al-Khazali and Pyun (2004), Luintel and
Paudyal (2006) and Hasan (2008). These studies report that in general stock prices
are positively related to goods prices. Our study, however, does not focus on this
relationship.
2
Atkins and Coe (2002) used the ARDL approach to test the Fisher effect for interest
rates in USA and Canada.
536 M. Rushdi et al. / Economic Modelling 29 (2012) 535543
into the model (2). The extended multivariate model is given as fol-
lows:
rsr
t

0

1

e
t

2
act
t

3
mp
t

t
3
where act is a measure for the real economic activity, and mp is a
measure for the monetary policy.
3
In Eq. (3), if the Fisher hypothesis
holds, then
1
=0. However, if Fama's proxy hypothesis holds, then

2
>0 and
1
=0. Whether or not does the monetary policy affect
real stock returns, and the magnitude and direction of that effect
(
3
) is an open issue which will be empirically tested in this paper.
In Section 5, we will consider various proxies for the variables act
and mp and investigate their effects on real stock returns. Further-
more, as mentioned before, both the expected ination
t
e
and ob-
served ination
t
series will be used to establish the long run level
relationships between the rsr and ination expressed in both models
(2) and (3).
3. Methodologies
This section provides a brief review of the methodologies adapted
in this paper: (i) the ARDL bound testing approach of Pesaran et al.
(2001), PSS hereafter, for testing the existence of a long run level re-
lationship. This method is found to be appealing, because it is applica-
ble to a set of time series albeit series are I(1) and/or I(0). In other
words, the ARDL method was shown to work regardless of the
order of integration the time series under consideration. The bias-
corrected bootstrap method of Kilian (1998) is employed for conduct-
ing reliable statistical inference on the long run parameters, which are
non-linear functions of parameters of the conditional error correction
model (CECM). This bootstrap method does not depend on the as-
sumption of the normality of the error distribution, which is often vi-
olated in practice.
3.1. ARDL bounds testings
Using the notations introduced by PSS, we consider a K-dimensional
vector time series Z
t
=(Y
t
, X
t
), where Y
t
is a scalar and X
t
is a (K1)1
vector. It is assumed that Z
t
follows a vector autoregressive model of
order p, denoted VAR(p), which can be written as
Z
t
t B
1
Z
t 1
: B
p
Z
tp
u
t
; 4
where is the K1 vector of intercepts, is the K1 vector of time
trend coefcients, B
i
's are the KK matrices of coefcients and u
t
is
the K1 vector of innovations with E(u
t
)=0 and E(u
t
u
t
)=
u
. It is as-
sumed that each component of Z
t
~I(0) or Z
t
~I(1). In the latter case, the
variables in Z
t
are allowed to be cointegrated. Note that Y
t
rsr
t
and
X
t

t
, in the bivariate model (2). Y
t
rsr
t
and X
t
(
t
, act
t
, mp
t
) in the
multivariate model (3).
Under the assumptions given in PSS, the CECM associated with
Eq. (4) is given by
Y
t
c
0
c
1
t
yy
Y
t1

yx;x
X
t1

X
p1
i1

i
Z
ti

X
t

t
; 5
and the conditional level relationship between Y
t
and X
t
is dened by
Y
t

0

1
t X
t
v
t
; 6
where
0
c
o
/
yy
,
1
c
1
/
yy
,
yx,x
/
yy
, while
y,x
(
yy
,
yx,
x
) and v
t
is a stationary error process. According to PSS, if Y
t
~I(0),
the Eq. (6) can be interpreted as the conditional long run level
relationship, while the vector contains the conditional long run
multipliers. If Y
t
~I(1), then Eq. (6) represents the cointegrating rela-
tionship. Further, PSS state that if
y,x
0 and
yx,x
=0, then Y
t
~I(0)
and Y
t
depends only on its own lagged level. On the other hand, if
y,
x
=0 and
yx,x
0, then Y
t
~I(1) and (Y
t
, X
t
) are cointegrated with the
cointegrating vector (1,
yx,x
). Further, if
y,x
=0 and
yx,x
=0, then
Y
t
~I(1) and there is no level relationship between Y
t
and X
t
.
The CECM in Eq. (5) derived from the underlying VAR(p) model in
Eq. (4), may also be interpreted as an autoregressive distributed lag
model (ARDL) of order p. In order to test for the absence of a level re-
lationship between Y
t
and X
t
in the CECM (Eq. (5)), a sequential test-
ing of the two null hypotheses, dened as:
H
A
0

yy
0and
yx;x
0
0
against H
A
1
:
yy
0and=or
yx;x
0
0
;
and H
B
0

yy
0 against H
B
1

yy
0
is conducted. If H
0
A
is not rejected, then there does not exist a long run
level relationship. The testing procedure is terminated. If this null is
rejected, then test for the null H
0
B
and if the latter is also rejected,
then there exists a level relationship between Y
t
and X
t
. Under the as-
sumptions of all variables being I(0) and all being I(1) respectively,
the lower and upper bounds of the critical values of the test statistics
for these hypotheses are tabulated in PSS. Under the null of H
0
A
, if
computed F-statistic falls outside the upper bound critical value at
the prescribed level of signicance, then the null hypothesis is
rejected. On the other hand, if the F-statistic is below the lower
bound critical value, then the null hypothesis is not rejected. Howev-
er, if the statistic falls within these bounds, then the decision is incon-
clusive. A similar decision rules apply to the t-statistic for testing the
null of H
0
B
. If these hypotheses tests establish the existence of level re-
lationship among the variables, we can then proceed to estimate the
long run and short run coefcients in Eq. (5).
The CECM model for our bivariate and multivariate relationships
given in models (2) and (3) can now be expressed as
rsr
t

0

1
rsr
t1

2

t1

X
p
i1

i
rsr
ti

X
q
j0

tj
u
t
7
and
rsr
t

0

1
rsr
t1

2

t1

3
act
t1

4
mp
t1

i1

i
rsr
ti

X
q
j0

tj

X
r
k0

k
act
tk

X
s
l0
mp
tl

t
: 8
The CECMs in Eqs. (7) and (8) can be referred to as ARDL models of
order (p,q) and order (p,q,r,s) respectively. The conditional long run
models can be obtained from the reduced form solution of Eqs. (7)
and (8) assuming the rst differenced variables jointly equal zero in
the long run equilibrium. For the bivariate and the multivariate models
respectively, these can be expressed as:
rsr
t

0

1

t
v
t
where
0
a
0
=a
1
and
1
a
2
=a
1
9
andrsr
t

0

1

t

2
act
t

3
mp
t

t
where
0

0
=
1
;
1

2
=
1
;
2

3
=
1
and
3

4
=
1
:
10
Note that the long runparameters of the models (9) and (10) are the
ratios of those of the corresponding CECMs (7) and (8) respectively.
3.1.1. Estimation of the long run parameters
Once the existence of the long run relation is established by
employing the ARDL bound testing, the estimates of the long run
3
Note that apart from real activity and monetary policy, several studies (Kaul and
Seyhun, 1990; Lee, 2003; Madsen, 2005) have highlighted the importance of other var-
iables such as relative prices, supply shocks or scal disturbances.
537 M. Rushdi et al. / Economic Modelling 29 (2012) 535543
parameters dened in Eqs. (9) and (10) can be computed as the func-
tions of the short run parameter (OLS) estimates of Eqs. (7) and (8).
However, the distributional properties of these long run estimators
in small to moderate samples are largely unknown. A normal approx-
imation is widely used in practice whose justication lies in the large
sample theories, with their standard errors derived traditionally
using the delta method. To explain this method briey, let =(/)
can be estimated as
^
^
^
; and
var
^

^
2

1
^

2
var ^ 2
^
^

cov ^ ;
^

^
^

!
2
var
^

!
: 11
The condence interval can then be calculated as
^
z
=2
^ 12
where (1)100% is the condence level and z
/2
is the (1/ 2)th
percentile of the standard normal distribution.
However, it is well-known that this asymptotic approximation is
not reliable in small samples. In particular, ^ estimated by the delta
method can be fairly inaccurate in small to moderate samples, and
the normality assumption is often violated in empirical applications.
As an alternative, we employ the bias-corrected bootstrap method
of Kilian (1998) to estimate condence intervals for the long run pa-
rameters implied from the ARDL models. This method is shown to
work well when the constructed parameters are themselves non-
linear functions of the parameters of related models, and robust to
the non-normal errors. This bootstrap method is well-known to pro-
vide reliable statistical inference in small to moderate samples.
4
In this paper, we provide only a brief description of the bias-
corrected bootstrap for simplicity. It involves two stages of the
bootstrap for ARDL models given in Eq. (7) or Eq. (8) based on
residual re-sampling. In the rst stage, small sample biases of
parameter estimates of Eq. (7) or Eq. (8) are estimated and, based
on these, the bias-corrected parameter estimates are obtained. In
the second stage, the residual bootstrap is again conducted to these
ARDL models, using the bias-corrected parameter estimates obtained
from the rst stage, to obtain bootstrap distribution of the long run
parameters given in Eq. (9) or Eq. (10). This bootstrap distribution
is used as an approximation to the sampling distribution of the long
run parameter estimators, based on which condence intervals are
obtained. The full details of the procedure can be found in Kilian
(1998) or from the authors on request.
4. Data and time series properties
This study uses quarterly data spanning the period 1969:2 to
2008:1. All data series are collected fromthe International Financial Sta-
tistics (IFS) CDROM, with an exception of the 90 day bank bill rate. The
90 day bank bill rate is obtained from the Reserve Bank of Australia
(RBA) website. The All Ordinaries Index, which is the Australian equity
index, representing a comprehensive well-diversied equity portfolio is
used to compute the stock returns. The real stock returns are calculated
as the rst difference of the real share price index and expressed in per-
centages, where the real share price index is generated by deating the
logarithmof nominal share price index by the logarithmof the consum-
er price index (cpi). The ination is dened as =(lcpi
t
lcpi
t 1
)100,
where the lcpi is the logarithmof consumer price index (cpi) series. Fur-
thermore, to derive the quarterly expected ination series (
e
), the
ARMA(p,q) processes with (p,q)=0,1,2,3,4 were tted to the observed
quarterly ination series in all three sample periods. The optimum
values for (p,q) that predicts the expected ination adequately were se-
lected by AIC and BIC criteria. They both selected (p,q)=(4,0) (that is,
AR(4) model) to be the best forecasting model.
Real economic activity (act) is represented by the growth rate of in-
dustrial production (ipg). To ensure the robustness of the results, an al-
ternate measure of the growth rate of real GDP (rgdpg) is also used. The
growth rates of seasonally adjusted real GDP (rgdp) and industrial pro-
duction (ip) indexes are dened as: rgdpg=(lnrgdp
t
lnrgdp
t 1
)
100 and ipg=(lnip
t
lnip
t 1
)100 respectively. As a proxy for the
monetary policy variable, a popular choice for Australia is the cash
rate, which is the current policy instrument of RBA, but this series is
available only from January 1990, and therefore, the 90 day bank bill
rate (ir) measured in percentage is used. As an alternate a monetary ag-
gregate measure, the seasonally adjusted M3 is also used for monetary
policy to ascertain the robustness of the empirical results. The growth
rate of M3 is dened m3g=(lM3
t
lM3
t 1
)100.
4.1. Time series properties of the data
Fig. 1 reports the time plots of all time series. The series shows a
change in the magnitude of volatility around 1990, mainly due to the
change of monetary policy of Australia towards the ination target-
ing. The rsr series have two extreme observations in 1974 and 1987,
corresponding to the oil price shock and stock market crash respec-
tively. Furthermore, the ir series shows a signicant fall in several
quarters starting at around 1989, probably due to the response of
RBA to the recession Australia experienced during the early 90s. On
the other hand, the ipg and rgdpg show lower volatilities since
1990:1. As was discussed in the introduction, in order to investigate
whether or not the data generating process for the stock returnsin-
ation relationship has fundamentally changed as a consequence of
the monetary policy change
5
in 1990, we divided the whole sample
period into two sub-periods: Period I (1969:1 to 1989:4) and Period
2 (1990:1 to 2008:1). Therefore, the investigation into stock
returnsination relationship was conducted in all three sample pe-
riods, namely full and two sub-sample periods.
Although the ARDL bounds testing method does not require pre-
testing of the data series for the order of integration as to if they are
I(1) or I(0), we briey discuss these order of integrations of the series
considered in this paper. The time plots of all series, except for ir,
show that there is no noticeable global trend in any of the series.
The ir shows a local trend in period 1. The ADF test results indicate
that rsr, rgdpg, ipg and m3g series are I(0). The series is found to
be I(1) in the whole sample, but I(0) in the two sub periods. The ir se-
ries is I(1) in the whole sample and in period 1 but I(0) in period 2.
Moreover, in order to examine if the order of integration has changed
as a result of the monetary policy change in the early 90s, we employ
the unit root test recently proposed by Carrion-I-Silvestre et al.
(2009) which allows for the presence of structural breaks.
6
We nd
that the only time series affected by this policy change is the ina-
tionary series. In the presence of a break in intercept in 1991:1, the
series is found to be I(0), while in the absence of such a break this se-
ries was found to be I(1). To save space, the unit root testing results
are not tabulated in this paper, but would be available from the au-
thors on request. Despite the attractiveness of the ARDL bounds test-
ing procedure for establishing long run relationships regardless of the
order of integration of data series used in modelling, the empirical
4
For reviews of the bootstrap methods and their applications in econometrics, see
Berkowitz and Kilian (2000), MacKinnon (2002) and Kim (2001). The use of the boot-
strap method for testing long run relationship in economics is becoming increasingly
popular in econometrics; see, for example, Swensen (2011).
5
The ination targeting process was not nalised until 199293, see Macfarlane
(1999) for a review of changes in Australian monetary policy. However Battelino et
al. (1997) identies that a major change in the operation of monetary policy occurred
in January 1990 when the RBA started announcing the changes in the overnight inter-
est rate making the changes in the stance of monetary policy clearer to the market
participants.
6
This test is an improvement of its precursors such as that of Perron (1989) in that it
allows for multiple breaks with unknown dates, both under the null and alternative hy-
potheses. We would like to thank the authors for making their GAUSS codes available.
538 M. Rushdi et al. / Economic Modelling 29 (2012) 535543
ndings of mixed results of I(1) and/or I(0) properties of the data series
makes the benets of ARDL bounds testing method evenmore promising.
5. Empirical analyses and results
In this section, we report and analyse the results of ARDL bounds
testings for the long run relationship between real stock returns and
ination in the context of bivariate and multivariate models for the
three sample periods. The LR model parameter estimates and their
condence intervals are computed rst by using the traditional OLS
and delta methods, and then the biassed-corrected bootstrap method.
These methodologies are briey discussed in Section 3.
5.1. ARDL bounds testings for the long run relationship between real
stock returns and ination in bivariate and multivariate models
The CECM's (7) and (8) were estimated for the quarterly data se-
ries by OLS. Following Pesaran and Shin (1999), we use Schwartz
rsr
rgdpg ipg
m3g ir

e
-60
-50
-40
-30
-20
-10
0
10
20
1970 1975 1980 1985 1990 1995 2000 2005
-1
0
1
2
3
4
5
6
1970 1975 1980 1985 1990 1995 2000 2005
-4
-3
-2
-1
0
1
2
3
4
1970 1975 1980 1985 1990 1995 2000 2005
-6
-4
-2
0
2
4
6
1970 1975 1980 1985 1990 1995 2000 2005
-4
0
4
8
12
16
20
1970 1975 1980 1985 1990 1995 2000 2005
4
6
8
10
12
14
16
18
20
1970 1975 1980 1985 1990 1995 2000 2005
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
1970 1975 1980 1985 1990 1995 2000 2005
Note: The vertical line corresponds to 1990:1
Fig. 1. Time plots of the data series.
539 M. Rushdi et al. / Economic Modelling 29 (2012) 535543
information criterion (SC) to determine the optimum lag length,
which is found to be one for both bivariate and multivariate models
across all three sample periods. Tables 1 and 2 respectively report
the ARDL bounds testing results for the existence of long run relation-
ships in the bivariate and multivariate models. According to a range of
diagnostic tests employed (which are given in the footnotes to these
tables), only the normality of the error termis violated and there is no
neglected autocorrelation or heteroscedasticity present in the resid-
uals of all models across the all three sample periods.
5.1.1. Long run real stock returns and ination relationship in bivariate
model
The results of ARDL bounds tests F and t for the Eq. (7) with series
and
e
respectively are reported in Table 1A and B. The critical
values of these test statistics are also reported in the footnotes to
these tables. In the sequential hypothesis testing to establish the
long run relationship between rsr and , the computed F-statistics
for the null of H
0
A
against H
1
A
(dened in Section 3.1) are 58.31,
31.65 and 24.02 for the full sample period, period 1 and period 2 re-
spectively, which are greater than the 1% upper bound critical value
of 7.84. Therefore, the null hypothesis H
0
A
of no long run level rela-
tionship is soundly rejected. Now, proceeding with testing the null
H
0
B
:
yy
=0 , the t-statistics for the whole sample, period 1 and period
2 are 10.80, 7.95 and 6.92 respectively, which are less than the
upper bound t critical value of 3.82. As a result, the null hypothesis
H
0
B
:
yy
=0 is also rejected. These results provide convincing statisti-
cal evidence for the existence of long run relationship between the
two variables real stock returns and ination. From the results pre-
sented in Table 1B, similar inference can be drawn on the relationship
between the rsr and
e
. Clearly, there exist long run relationships be-
tween rsr and
e
, and between rsr and .
5.1.2. Long run real stock returns and ination relationship in multivariate
model
The results of ARDL bounds testing for the multivariate model (8)
with observed ination () and expected ination (
e
) are tabulated
in Table 2A and B respectively. In addition to ination, two more
explanatory variables, namely growth rate of industrial production
(ipg) and interest rate (ir) were included as proxies for the real activ-
ity (act) and monetary policy (mp); see Section 2 for details. The
F-statistics for the null H
0
A
(reported in Table 2A) are 27.84, 14.95
and 12.15 respectively for the full sample period, period 1 and period
2. These values again lie well above the upper critical value of 5.61 for
k=3, where k in the number of explanatory variables, at the 1% sig-
nicance level. Therefore, the null H
0
A
of no long run relationship is
rejected. Subsequently, the t-statistics for the null H
0
B
are computed
as 10.43, 7.65, and 6.72 for the whole sample period, period
1 and period 2 respectively, which are less than the upper critical
value of 4.37 for k=3. Thus, the null that H
0
B
=0 is rejected,
which conrms the existence of long run relationship between the
variables. Fromthe results presented in Table 2B, the same conclusion
can be made on the long run relationship between the real stock
returns and expected ination. In this empirical analysis, the sequen-
tial ARDL bounds testings provide strong evidence for the existence of
long run relationship among the variables in the multivariate models
exhibited in Table 2A and B. We have also used other proxies, growth
rate of real GDP (rgdpg) and money supply growth rate (m3g) for the
economic activity and monetary policy respectively, and the ARDL
bounds testings results are found to be robust across various proxy
variables.
5.2. Estimation of long run model parameters
The OLS estimates of CECMs (7) and (8) reported in Tables 1 and 2
are in turn used to calculate the long run model parameters given in
Eqs. (9) and (10) for the bivariate and multivariate models respec-
tively. Because the LR parameters are the ratios of those of CECMs,
the condence intervals for the former were estimated by delta
methods and the results are reported in Table 3A and B, and these re-
sults reveal that the observed ination has a signicant negative ef-
fect on the real stock returns in the long run, but only in the whole
sample and subsample period 2 in the bivariate model. However,
this effect is signicant only for the whole sample period in the mul-
tivariate model. On the other hand, the expected ination series does
not have any statistically signicant effect on the real stock returns in
Table 1
A: The OLS of ARDL model parameters and the bounds tests results for real stock returns-observed ination in the bivariate model.
Variables Whole sample (1969:2 to 2008:1) Period 1 (1969:2 to 1989:4) Period 2 (1990:1 to 2008:1)
rsr(1) 0.88 (0.08) 0.89 (0.11) 0.91 (0.13)
(1) 1.61 (0.69) 2.20 (1.39) 3.39 (1.39)
2.68 (0.76) 3.10 (1.23) 3.23 (1.04)
C 2.54 (1.21) 4.32 (3.21) 3.19 (1.17)
F-stat 58.31 31.65 24.02
t-stat 10.80 7.95 6.92
B: The OLS of ARDL model parameters and the bounds tests results for real stock returnsexpected ination in the bivariate model
rsr(1) 0.89 (0.08) 0.90 (0.11) 0.90 (0.14)

e
(1) 0.90 (0.87) 0.40 (1.80) 1.69 (1.88)

e
3.01 (3.15) 3.96 (4.86) 0.98 (3.84)
c 1.48 (1.46) 0.43 (3.84) 2.29 (1.69)
F-stat 57.80 31.23 22.05
t-stat 10.74 7.89 6.60
Notes: The standard errors given in parentheses. is observed ination and
e
is expected ination.
The p-values of the BoxLjung test for no serial correlation against that of order 10, BreuschPagan LM test for no heteroscedasticity, and ARCH test for no ARCH against that of order
4 are all above 20%. The p-value for the JarqueBera test for normality is zero for all three sample periods.
The model estimated is:
rsr
t

0

1
rsr
t1

2

t1

X
p
i1

i
rsr
ti

X
q
j0

tj
u
t
F: ARDL bounds test for H
0
A
; for k=1, the upper bound critical values are 7.84, 5.73 and 4.78 at 0.01, 0.05 and 0.10 levels. The respective lower bound critical values are 6.84, 4.94 and
4.04 respectively.
t: ARDL bounds test for H
0
B
; for k=1, the upper bound critical values are 3.82, 3.22 and 2.91 at 0.01, 0.05 and 0.10 levels. The respective lower bound critical values are 3.43,
2.86 and 2.57.
540 M. Rushdi et al. / Economic Modelling 29 (2012) 535543
the long run in all three sample periods in the bivariate model, and
these ndings are the same in multivariate long run model as well.
Further, in the multivariate model, the real economic activity and
monetary policy variables also have no effects on real stock returns.
Note that the LR parameters are nonlinear functions of those of
CECMs, and as was argued before, the OLS based LR parameter esti-
mates may be biassed in small samples. In addition, the delta method
based condence intervals obtained under the assumption of normal-
ity are highly likely to provide inaccurate and unreliable inferential
outcomes. In these circumstances, the biassed corrected bootstrap
method is appealing for estimating LR parameters and their con-
dence intervals, which we employed and the results are reported in
Table 4A and B. They indicate that the observed ination has a signif-
icant and negative effect on real stock returns, but the expected
Table 3
A: Point estimate by OLS and 95% interval estimate by delta method of long run ination parameter in the bivariate ARDL model.
Whole sample Period1 Period 2
Panel 1: results with observed ination
1.83 (3.30 0.35) 2.46 (5.43 0.51) 3.73 (6.60 0.86)
Panel 2: results with expected ination

e
1.00 (2.90 0.89) 0.45 (4.37, 3. 47) 1.89 (5.90 2.12)
B: Point estimate by OLS and 95% interval estimate by delta method of long run ination parameter in the multivariate ARDL model
Panel 1: results with observed ination
2.02 (3.85 0.20) 2.93 (6.18 0.32) 2.21 (5.49 1.07)
act 0.57 (1.77 0.64) 0.78 (2.60 1.04) 0.50 (2.09 1.08)
mp 0.08 (0.38 0.54) 0.10 (0.61, 0.80) 0.77 (1.63 0.08)
Panel 2: results with expected ination

e
1.02 (3.51 1.48) 1.41 (5.99, 3.17) 0.76 (6.21 4.70)
act 0.69 (1.97 0.59) 0.80 (2.81 1.22) 0.64 (2.39 1.11)
mp 0.08 (0.58 0.41) 0.04 (0.70 0.77) 0.95 (1.90 0.01)
Notes: The 95% condence intervals are calculated by delta method and given in parentheses.
is observed ination and
e
is expected ination.
The long run level models derived from the corresponding ARDL models are:
rsr
t

0

1

t
v
t
rsr
t

0

1

t

2
act
t

3
mp
t

t

1
is the long run ination parameter. The parameters of these models are computed as functions of the corresponding ARDL model parameter (OLS) estimates.
Table 2
A: The OLS of ARDL model parameters and the bounds tests results for real stock returns-observed ination in the multivariate model.
Variables Whole sample (1969:2 to 2008:1) Period 1 (1969:2 to 1989:4) Period 2 (1990:1 to 2008:1)
rsr(1) 0.88 (0.08) 0.89 (0.12) 0.90 (0.13)
(1) 1.77 (0.84) 2.61 (1.51) 1.98 (1.54)
act(1) 0.50 (0.53) 0.69 (0.82) 0.45 (0.72)
mp(1) 0.07 (0.21) 0.09 (0.32) 0.69 (0.38)
2.77 (0.80) 3.24 (1.26) 2.63 (1.09)
act 0.12 (0.40) 0.07 (0.62) 0.01 (0.51)
mp 0.27 (0.47) 0.29 (0.62) 2.57 (1.49)
c 2.43 (1.74) 4.76 (4.81) 6.62 (2.30)
F-stat 27.84 14.95 12.15
t-stat 10.43 7.65 6.72
B: The OLS of ARDL model parameters and the bounds tests results for real stock returnsexpected ination in the multivariate model
rsr(1) 0.88 (0.08) 0.89 (0.12) 0.89 (0.13)

e
(1) 0.89 (1.12) 1.25 (2.07) 0.66 (2.48)
act(1) 0.61 (0.57) 0.71 (0.90) 0.57 (0.78)
mp(1) 0.07 (0.22) 0.03 (0.33) 0.84 (0.43)

e
1.98 (3.27) 3.87 (5.13) 1.68 (3.92)
act 0.02 (0.42) 0.07 (0.66) 0.18 (0.54)
mp 0.30 (0.49) 0.19 (0.65) 3.46 (1.48)
c 2.48 (1.86) 2.31 (5.63) 6.82 (2.46)
F-stat 27.67 14.70 11.74
t-stat 10.35 7.52 6.63
Notes: See notes in Table 1.
The model estimated is:
rsr
t

0

1
rsr
t1

2

t1

3
act
t1

4
mp
t1

X

i1

i
rsr
ti

X
q
j0

tj

X
r
k0

k
act
tk

X
s
l0
mp
tl

t
:
The critical values of F: ARDL bounds test for H
0
A
; for k=3, the upper bound critical values are 5.61, 4.35 and 3.77 at 0.01, 0.05 and 0.10 levels. The respective lower bound critical
values are 4.29, 3.23 and 2.72 respectively.
t: ARDL bounds test for H
0
B
; for k=3, the upper bound critical values are 4.37, 3.78 and 3.46 at 0.01, 0.05 and 0.10 levels. The respective lower bound critical values are 3.43,
2.86 and 2.57. The industrial production growth rate (ipg) and interest rate (ir) were used as proxies for real economic activity (act) and monetary policy (mp) respectively.
541 M. Rushdi et al. / Economic Modelling 29 (2012) 535543
ination has no signicant effect and they hold for all models and
sample periods studied in this paper. Moreover, these ndings reveal
that the change in monetary policy had not altered the nature of the
long run relationship between real stock returns and ination.
6. Conclusion
Testing for the presence of long run relationship between stock
returns and ination has been very popular in the empirical literatures
in economics and nance. If indeed such a relationship exists, then the
common stocks can be used to hedge against the ination. Under the
Fisher hypothesis, empirical testing for the aforementioned relationship
is equivalent to testing that expected ination has no effect on real stock
returns. This paper conducts an empirical investigation into the long
run real stock returns-expected ination and real stock returns
observed ination relationships by employing the ARDL bounds test-
ings. The existence of these long run relationships was examined in bi-
variate as well as multivariate models. Furthermore, the long run
parameters derived in terms of those of conditional error correction
models are nonlinear functions of the later. Therefore, the traditional
OLS and delta estimation methods for these long run parameters can
be problematic in small to moderate samples, and works under asymp-
totic normality, which does not hold in our empirical investigation. To
overcome these problems, we employ the bias-corrected bootstrap
method, which provides consistent and unbiassed estimates for the
long run parameters and reliable condence intervals. The bootstrap
method does not assume normality, and hence it is robust to non-
normal errors.
The empirical results based on the bias-corrected bootstrap meth-
od indicate a signicant and negative effect of observed ination on
real stock returns an insignicant effect of expected ination on real
stock returnsrelationship, and the latter nding implies that com-
mon stocks can be effectively used for hedging against expected ina-
tion in Australia. However, the shift in monetary policy in the early
1990 does not appear to have changed the stability of the fundamen-
tal long run relationship between real stock returns and ination. Be-
cause of the robustness of Australian economy to the current global
nancial crisis, these ndings have important implications for long
term domestic and foreign investors in Australia.
Acknowledgements
We would like to thank two anonymous referees of this journal for
their helpful comments on earlier drafts of this paper. Earlier versions
of this paper were presented to the Third International Business Re-
search Conference, 2006, Melbourne, Australia and to the Australian
Conference of Economists, 2008, Gold Coast, Australia. We thank the
conference participants for their comments.
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Whole sample Period 1 Period 2
Panel 1: results with observed ination
2.28 (3.61, 0.95) 2.98 (5.64, 0.49) 1.82 (3.75, 0.29)
Panel 2: results with expected ination

e
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B: The point and 95% interval estimates of the long run ination parameter by biassed corrected bootstrap method in the multivariate ARDL model
Panel 1: results with observed ination
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Panel 2: results with expected ination

e
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act 0.07 (1.00, 0.77) 0.02 (1.46, 1.44) 0.29 (1.14, 0.51)
mp 0.16 (0.68, 0.31) 0.05 (0.80, 0.63) 0.06 (0.86, 0.81)
Notes: See notes in Table 3.
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