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Junior Can't Borrow: A New Perspective on the Equity Premium Puzzle

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  • George M. Constantinides
  • John B. Donaldson
  • Rajnish Mehra

Abstract

Ongoing questions on the historical mean and standard deviation of the return on equities and bonds and on the equilibrium demand for these securities are addressed in the context of a stationary, overlapping-generations economy in which consumers are subject to a borrowing constraint. The key feature captured by the OLG economy is that the bulk of the future income of the young consumers is derived from their wages forthcoming in their middle age, while the bulk of the future income of the middle-aged consumers is derived from their savings in equity and bonds. The young would like to borrow and invest in equity but the borrowing constraint prevents them from doing so. The middle-aged choose to hold a diversified portfolio that includes positive holdings of bonds, and this explains the demand for bonds. Without the borrowing constraint, the young borrow and invest in equity, thereby decreasing the mean equity premium and increasing the rate of interest.

Suggested Citation

  • George M. Constantinides & John B. Donaldson & Rajnish Mehra, 2002. "Junior Can't Borrow: A New Perspective on the Equity Premium Puzzle," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 117(1), pages 269-296.
    • Handle: RePEc:oup:qjecon:v:117:y:2002:i:1:p:269-296.
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    File URL: http://hdl.handle.net/10.1162/003355302753399508
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    References listed on IDEAS

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    1. Mehra, Rajnish & Prescott, Edward C., 1988. "The equity risk premium: A solution?," Journal of Monetary Economics, Elsevier, vol. 22(1), pages 133-136, July.
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    JEL classification:

    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading

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