Asset Prices and Business Cycles with Financial Shocks

Abstract

We develop a production based asset pricing model with financially constrained firms to explain the observed high asset price volatility. Investment opportunities are scarce and firms face two shocks: classic productivity shocks and financial shocks that affect the tightness of the financial constraint. The source of asset price volatility in the model is the interaction between the scarcity of investment opportunities and time variation in the tightness of the financial constraint. We calibrate the model to the U.S. data and find that it generates a volatility in the price of equity comparable to the observed aggregate stock market volatility. The model also fits key aspects of the behavior of aggregate quantities, in particular, the volatility of aggregate consumption and investment.

Keywords: General Equilibrium, Business Cycles, Production Based Asset Pricing

JEL Classification: E20, E32, G12