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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

We show that the preferences suggested by Greenwood, Hercowitz and Huffman (GHH), which are quite common in real business cycle (RBC) models of small open economies, are not suited for reproducing both the business cycle and the equity premium facts of a small open economy. We show that by assuming a moderate degree of a wealth effect on labor supply, together with some limitations on labor supply (in the form of real wage rigidity), we can increase the volatility of the stochastic discount factor (SDF), thereby increasing the equity premium and improving the fit of the business cycle moments. We also find that under the aforementioned assumptions, a shock to the realized return on foreign bonds can help in reproducing the equity premium.

Suggested Citation

  • Borenstein, Eliezer & Elkayam, David, 2014. "The equity premium in a small open economy and an application to Israel," Economic Modelling, Elsevier, vol. 43(C), pages 81-99.
    • Handle: RePEc:eee:ecmode:v:43:y:2014:i:c:p:81-99
    DOI: 10.1016/j.econmod.2014.07.047
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    1. Maya Shaton, 2017. "The Display of Information and Household Investment Behavior," Finance and Economics Discussion Series 2017-043, Board of Governors of the Federal Reserve System (U.S.).

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    More about this item

    Keywords

    Asset pricing; Equity premium; Real business cycle; Small open economy; Stochastic discount factor; Labor supply;
    All these keywords.

    JEL classification:

    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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