I study asset prices in a two-agent macroeconomic model with two key features: limited stock market participation and heterogeneity in the elasticity of intertemporal substitution in consumption (EIS). The model is consistent with some prominent features of asset prices, such as a high equity premium; relatively smooth interest rates; procyclical stock prices; and countercyclical variation in the equity premium, its volatility, and in the Sharpe ratio. In this model, the risk-free asset market plays a central role by allowing non-stockholders (with low EIS) to smooth the fluctuations in their labor income. This process concentrates non-stockholders’ labor income risk among a small group of stockholders, who then demand a high premium for bearing the aggregate equity risk. Furthermore, this mechanism is consistent with the very small share of aggregate wealth held by non-stockholders in the US data, which has proved problematic for previous models with limited participation. I show that this large wealth inequality is also important for the model’s ability to generate a countercyclical equity premium. When it comes to business cycle performance the model’s progress has been more limited: consumption is still too volatile compared to the data, whereas investment is still too smooth. These are important areas for potential improvement in this framework.
Published in: _Econometrica_ (Vol. 77, No. 6, November 2009, pp. 1711-1750) https://doi.org/10.3982/ECTA6658.