We provide an explanation for the high equity premium and related puzzles based on persistent dividend growth and idiosyncratic income risk that have previously been shown to have potential for explaining the variance of stock prices, and the low risk-free rate. We show how these two elements can be integrated in a tractable framework to offer a convincing overall account for the history of U.S. asset prices. Our main explanation for the high equity premium is that there is a small persistent component to changes in dividend growth. This component, driven by the "business cycle," makes equity prices very volatile, and hence a poor insurance instrument. The model also explains the extreme volatility of stock prices: the price-dividend ratio predicted by the model based on U.S. consumption data from 1891-2001 has a correlation of 72% with the actual price-dividend ratio in the S&P 500. In addition, we show that a high equity premium is consistent with plausible levels of risk aversion and a low inter-temporal elasticity of substitution, as long as consumption growth is less persistent than income growth.
©2011 Walter de Gruyter GmbH & Co. KG, Berlin/Boston
