Equities and the economy: another intertemporal anomaly

Intertemporal optimization models of the macroeconomy are consistent with several features of the business cycle, and these models have become familiar tools for analyzing economic cycles and the propagation of economic shocks. Critics of this dynamic equilibrium approach have pointed out, however, that the models often fail to replicate important features of both labor and financial markets. This paper identifies another financial market anomaly of intertemporal optimization models, the equity-economy puzzle, which is a negative correlation between equity prices and future economic growth. That is, these models are often inconsistent with the positive correlation between equity prices and future economic growth found empirically. ; The equity-economy puzzle tends to emerge in intertemporal models with high risk aversion. Because the equity premium puzzle has led researchers to consider models with high risk aversion, they need to recognize that this strategy can lead to another anomaly. The paper explains why high risk aversion generates the equity-economy puzzle. The paper also shows that an intertemporal optimization model with nonexpected utility preferences can be consistent with the positive correlation between equity markets and future economic growth.