Hang Bai (UConn) and I have just circulated our new working paper titled “Searching for the equity premium” (paper, slides).
We view this work as a solid progress report toward the holy grail of macro-finance, which (in our view) is a unified theory of asset prices and business cycles.
The persistence of the Mehra-Prescott (1985) equity premium puzzle in general equilibrium production economies has given rise to a long-standing dichotomy in macro-finance. Finance specifies “exotic” preferences and exogenous cash flow dynamics to match asset prices but ignore firms (Campbell and Cochrane 1999; Bansal and Yaron 2004; Barro 2006). Macroeconomics analyzes full-fledged dynamic stochastic general equilibrium (DSGE) models but ignore asset prices with primitive preferences (Christiano, Eichenbaum, and Evans 2005; Smets and Wouters 2007).
This macro-finance dichotomy has left many important questions unanswered. What are the microfoundations underlying the exogenously specified, often complicated cash flow dynamics in finance models (Bansal, Kiku, and Yaron 2012; Nakamura, Steinsson, Barro, and Ursua 2013)? What are the essential ingredients in the production side that can endogenize the key elements of cash flow dynamics necessary to explain the equity premium? To what extent do time-varying risk premiums matter quantitatively for macroeconomic dynamics? How large is the welfare cost of business cycles in a general equilibrium production economy that replicates the equity premium?
We embed the standard Diamond-Mortensen-Pissarides search model of equilibrium unemployment into a DSGE framework with recursive utility and capital accumulation.
Highlights of our quantitative results include:
In all, the DSGE model with recursive utility, search frictions, and capital accumulation is a good start to forming a unified theory of asset prices and business cycles.