Political Cycles and Stock Returns
47 Pages Posted: 1 Feb 2017 Last revised: 26 Nov 2017
Date Written: November 23, 2017
We develop a model of political cycles driven by time-varying risk aversion. Heterogeneous agents make two choices: whether to work in the public or private sector and which of two political parties to vote for. The model implies that when risk aversion is high, agents are more likely to elect the party promising more fiscal redistribution. The model predicts higher average stock market returns under Democratic than Republican presidencies, explaining the well-known "presidential puzzle." Under sufficient complementarity between the public and private sectors, the model also predicts faster economic growth under Democratic presidencies, which is observed in the data.
Keywords: political cycles, risk aversion, presidential puzzle
JEL Classification: G12, G18, D72, P16
Suggested Citation: Suggested Citation