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

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.