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The equity premium in a small open economy, and an application to Israel

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  • Borenstein, Eliezer
  • Elkayam, David

Abstract

In this paper we attempt to reproduce both the business cycle facts and the equity premium of the Israeli economy—an economy which is "typical" in the sense that investment is much more volatile than output (and consumption). We show that GHH preferences, which are quite common in RBC models of small open economies, are not suited for reproducing both the business cycle and the equity premium facts of a "typical" small open economy. We found that a way to progress is to "correct" the GHH preferences by adding some degree of wealth effect on labor supply. That is, by switching to the Jaimovich-Rebelo (2006) type of preferences. However, in this case we also need to add to the model some kind of limitations on labor supply (we used both real wage rigidity and habits in labor). Our main finding is that the use of Jaimovich-Rebelo preferences considerably improves the results relative to that achieved by GHH preferences. The reason for this is that the GHH preferences are characterized by a relatively high degree of substitutability between consumption and leisure and this moderates the volatility of the stochastic discount factor (SDF). By adding some degree of wealth effect we can achieve a significant increase in the volatility of the SDF, and hence an increase in the equity premium and in the volatility of investment. Following the relevant literature we used three shocks: to productivity, to government expenditure and to the world interest rate. Our analysis suggests that by adding one or more of two kinds of shocks: shocks to wealth and shocks to the real exchange rate – one can achieve a significant progress in reproducing both the business cycle facts and the equity premium.

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Bibliographic Info

Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 43909.

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Date of creation: 01 Jan 2013
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Handle: RePEc:pra:mprapa:43909

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Keywords: Equity Premium; Asset Pricing; Business Cycle; Small Open Economy;

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References

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  1. Greenwood, Jeremy & Hercowitz, Zvi & Huffman, Gregory W, 1988. "Investment, Capacity Utilization, and the Real Business Cycle," American Economic Review, American Economic Association, vol. 78(3), pages 402-17, June.
  2. De Graeve, Ferre & Dossche, Maarten & Emiris, Marina & Sneessens, Henri & Wouters, Raf, 2010. "Risk Premiums and Macroeconomic Dynamics in a Heterogeneous Agent Model," Working Paper Series 236, Sveriges Riksbank (Central Bank of Sweden).
  3. Mendoza, Enrique G, 1991. "Real Business Cycles in a Small Open Economy," American Economic Review, American Economic Association, vol. 81(4), pages 797-818, September.
  4. Harald Uhlig, 2007. "Explaining Asset Prices with External Habits and Wage Rigidities in a DSGE Model," SFB 649 Discussion Papers SFB649DP2007-003, Sonderforschungsbereich 649, Humboldt University, Berlin, Germany.
  5. Correia, I. & Rabelo, S. & Naves, J.C., 1994. "Business Cycles in a Small Open Economy," RCER Working Papers 382, University of Rochester - Center for Economic Research (RCER).
  6. Nir Jaimovich & Sergio Rebelo, 2006. "Can News About the Future Drive the Business Cycle?," NBER Working Papers 12537, National Bureau of Economic Research, Inc.
  7. Jaccard, Ivan, 2010. "Asset pricing, habit memory, and the labor market," Working Paper Series 1163, European Central Bank.
  8. Jermann, Urban J., 1998. "Asset pricing in production economies," Journal of Monetary Economics, Elsevier, vol. 41(2), pages 257-275, April.
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