Searching for the Equity Premium

Fisher College of Business Working Paper No. 2020-03-023

Charles A. Dice Working Paper No. 2020-23

72 Pages Posted: 20 Oct 2020

See all articles by Hang Bai

Hang Bai

University of Connecticut - Department of Finance

Lu Zhang

Ohio State University - Fisher College of Business; National Bureau of Economic Research (NBER)

Multiple version iconThere are 2 versions of this paper

Date Written: October 19, 2020

Abstract

Labor market frictions are crucial for the equity premium in production economies. A dynamic stochastic general equilibrium model with recursive utility, search frictions, and capital accumulation yields a high equity premium of 4.26% per annum, a stock market volatility of 11.8%, and a low average interest rate of 1.59%, while simultaneously retaining plausible business cycle dynamics. The equity premium and stock market volatility are strongly countercyclical, while the interest rate and consumption growth are largely unpredictable. Because of wage inertia, dividends are procyclical despite consumption smoothing via capital investment. The welfare cost of business cycles is huge, 29%.

Keywords: The equity premium puzzle, macro finance, DSGE, search frictions, recursive utility, capital accumulation, projection, the welfare cost

JEL Classification: E32, E44, G12, J23

Suggested Citation

Bai, Hang and Zhang, Lu, Searching for the Equity Premium (October 19, 2020). Fisher College of Business Working Paper No. 2020-03-023, Charles A. Dice Working Paper No. 2020-23, Available at SSRN: https://ssrn.com/abstract=3714971 or http://dx.doi.org/10.2139/ssrn.3714971

Hang Bai

University of Connecticut - Department of Finance ( email )

School of Business
2100 Hillside Road
Storrs, CT 06269
United States

Lu Zhang (Contact Author)

Ohio State University - Fisher College of Business ( email )

2100 Neil Avenue
Columbus, OH 43210-1144
United States
585-267-6250 (Phone)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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