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Predictions of the Price of Capital

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  • Edward Prescott
  • Ellen McGrattan

Abstract

A central puzzle for asset pricing theory is that stock prices are much more volatile than corporate dividends. One possible resolution is to modify standard models by introducing stochastic discount factors that induce large variation in prices for relatively smooth sequences of dividends. But this ``solution'' does not help us with the deeper puzzle: measured values of corporate capital do not vary enough to justify the enormous variation in stock prices. Since the value of capital is itself equal to the discounted stream of dividends, adding stochastic discount factors only leads to counterfactual predictions for the value of the capital stock. In this paper, we consider factors that generate small movements in the resource cost of capital and large movements in the price of capital. The factors that we investigate are: time-varying tax rates; adjustment costs; irreversibilities in investment; constraints on investment that are sometimes binding; entry and exit of equity-issuing firms; changes in the price and quantity of intangible capital; and shifts in the marginal investor. Our goal is to determine the quantitative impact of each.

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Bibliographic Info

Paper provided by Society for Economic Dynamics in its series 2004 Meeting Papers with number 136.

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Date of creation: 2004
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Handle: RePEc:red:sed004:136

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Keywords: Asset pricing; productive capital;

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