Increasing Borrowing Costs and the Equity Premium

Abstract

Simulating a realistic-sized equity premium in macroeconomic models has proved a daunting challenge, hence the "equity premium puzzle." "Resolving'' the puzzle requires heavy lifting. Precise choices of particular preferences, shocks, technologies, and hard borrowing constraints can do the trick, but haven't stopped the search for a simpler and more robust solution.

This paper suggests that soft, but rapidly rising borrowing costs, imbedded in an otherwise standard OLG model can work. Its model features ten periods, isoelastic preferences with modest risk aversion, Cobb-Douglas production, realistic shocks, and reasonable fiscal policy. Absent borrowing costs, the model's equity premium is extremely small. Adding the costs readily produces large equity premiums.

These results echo, but also differ from those of Constantinides, Donaldson, and Mehra (2002). In their model, hard borrowing constraints on the young can produce large equity premiums. Here soft, but rising borrowing costs on all generations are needed.

The solution method builds on Hasanhodzic and Kotlikoff (2013), which uses Marcet (1988) and Judd, Maliar, and Maliar (2009, 2011) to overcome the curse of dimensionality.

Keywords: Equity Premium, Borrowing Constraints, Aggregate Shocks, Incomplete Markets, Stochastic Simulation

JEL Classification: G11, G12, D91, D58, C63, C68