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Junior Can't Borrow: A New Perspective on the Equity Premium Puzzle

  • George M. Constantinidies
  • John B. Donaldson
  • Rajnish Mehra

Ongoing questions on the historical mean and standard deviation of the return on equities and bonds and on the equilibrium demand for these securities are addressed in the context of a stationary, overlapping-generations economy in which consumers are subject to a borrowing constraint. The key feature captured by the OLG economy is that the bulk of the future income of the young agents is derived from their wages forthcoming in their middle age, while the bulk of the future income of the middle-aged agents is derived from their savings in equity and bonds. The young would like to borrow and invest in equity, but the borrowing constraint prevents them from doing so. The middle-aged choose to hold a diversified portfolio that includes positive holdings of bonds, and this explains the demand for bonds. Without the borrowing constraint, the young borrow and invest in equity, thereby decreasing the mean equity premium and increasing the rate of interest.

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File URL: http://www.nber.org/papers/w6617.pdf
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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 6617.

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Date of creation: Jun 1998
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Publication status: published as Constantinides, George M., John B. Donaldson and Rajnish Mehra. "Junior Can't Borrow: A New Perspective On The Equity Premium Puzzle," Quarterly Journal of Economics, 2002, v107(1,Feb), 269-296.
Handle: RePEc:nbr:nberwo:6617
Note: AP
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  1. Mehra, Rajnish & Prescott, Edward C., 1988. "The equity risk premium: A solution?," Journal of Monetary Economics, Elsevier, vol. 22(1), pages 133-136, July.
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