On March 11, 1994, the New York Stock Exchange Composite was trading at 16.9 times earnings, and the average dividend yield across stocks on the exchange was 2.5%. The Treasury bond rate on that date was 6.95%. The economy was expected to grow 2.5% a year, in real terms, in the long term, and the consensus estimate for inflation, in the long term, was 3.5%. (Market risk premium is 5.5%.)

a. Based on these inputs, estimate the appropriate PE ratio for the exchange.

b. What growth rate in dividends/earnings would justify the PE ratio on March 11, 1994?

c. Would it matter whether this higher growth comes from higher inflation or higher real growth? Why?