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Pessimistic beliefs under rational learning: quantitative implications for the equity premium puzzle

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  • Massimo Guidolin

Abstract

In the presence of infrequent but observable structural breaks, we show that a model in which the representative agent is on a rational learning path concerning the real consumption growth process can generate high equity premia and low risk-free interest rates. In fact, when the model is calibrated to U.S. consumption growth data, average risk premia and bond yields similar to those displayed by post- depression (1938-1999) U.S. historical experience are generated for low levels of risk aversion. Even ruling out pessimistic beliefs, recursive learning inflates the equity premium without requiring a strong curvature of the utility function. Simulations reveal that other moments of equilibrium asset returns are easily matched, chiefly excess volatility and the presence of ARCH effects. These findings are robust to a number of details of the simulation experiments, such as the number and dating of the breaks.

Suggested Citation

  • Massimo Guidolin, 2005. "Pessimistic beliefs under rational learning: quantitative implications for the equity premium puzzle," Working Papers 2005-005, Federal Reserve Bank of St. Louis.
  • Handle: RePEc:fip:fedlwp:2005-005
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    References listed on IDEAS

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    Cited by:

    1. Massimo Guidolin, 2006. "High equity premia and crash fears - Rational foundations," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 28(3), pages 693-708, August.
    2. repec:eee:dyncon:v:82:y:2017:i:c:p:312-330 is not listed on IDEAS
    3. George M. Constantinides, 2006. "Market Organization And The Prices Of Financial Assets," Manchester School, University of Manchester, vol. 74(s1), pages 1-23, September.

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    Keywords

    Assets (Accounting) ; Rational expectations (Economic theory);

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