Working Paper

Pessimistic beliefs under rational learning: quantitative implications for the equity premium puzzle

Abstract: In the presence of infrequent but observable structural breaks, we show that a model in which the representative agent is on a rational learning path concerning the real consumption growth process can generate high equity premia and low risk-free interest rates. In fact, when the model is calibrated to U.S. consumption growth data, average risk premia and bond yields similar to those displayed by post- depression (1938-1999) U.S. historical experience are generated for low levels of risk aversion. Even ruling out pessimistic beliefs, recursive learning inflates the equity premium without requiring a strong curvature of the utility function. Simulations reveal that other moments of equilibrium asset returns are easily matched, chiefly excess volatility and the presence of ARCH effects. These findings are robust to a number of details of the simulation experiments, such as the number and dating of the breaks.

Keywords: Assets (Accounting); Rational expectations (Economic theory);

Status: Published in Journal of Economics and Business, March-April 2006, 58(2), pp. 85-118

Bibliographic Information

Provider: Federal Reserve Bank of St. Louis

Part of Series: Working Papers

Publication Date: 2005

Number: 2005-005