The results of studies by Fama and Schwert (1977), Chen, Roll and Ross (1986), Nelson (1976) and Jaffe and Mandelker (1976) pointed to a negative relation between inflation and stock prices. We hypothesize similarly: an increase in the rate of inflation is likely to lead to economic tightening policies, which in turn increases the nominal risk-free rate and hence raises the discount rate in the valuation model (equation 1). The effect of a higher discount rate would not necessarily be neutralized by an increase in cash flows resulting from inflation, primarily because cash flows do not generally grow at.
