THE EQUITY PREMIUM A Puzzle* Rajnish MEHRA
Columbia University, New York, N Y 10027, USA
E d w a r d C. P R E S C O T T
Federal Reserve Bank of Minneapolis University of Minnesota, Minneapolis, MN 5545.5, USA.
Restrictions that a class of general equilibrium models place upon the average returns of equity and Treasury billsare found to be strongly violated by the U.S. data in the 1889-1978 period. This result is robust to model specification and measurement problems. We conclude that, most likely, an equilibrium model which is not an Arrow-Debreu economy will be the one that Simultaneously rationalizes both historically observed large average equity return and the small average risk-free return.
1. IntroductionH i s t o r i c a l l y the average r e t u r n o n equity has far exceeded the average r e t u r n o n s h o r t - t e r m virtually default-free debt. Over the n i n e t y - y e a r p e r i o d 1889-1978 the a v e r a g e r e a l a n n u a l yield o n the S t a n d a r d a n d P o o r 500 I n d e x was seven p e r c e n t , while the average yield o n s h o r t - t e r m d e b t was less t h an one percent. T h e q u e s t i o n a d d r e s s e d in this p a p e r is whether this large differential in a v e r a g e yields c a n b e a c c o u n t e d for b y m o d e l s that a b s t r a c t f r o m t r a n s a c t i o n s costs, l i q u i d i t y constraints a n d other frictions a b s e n t in the A r ~ o w - D e b r e u set-up. O u r finding is that it c a n n o t be, at least n o tfor the class of economies c o n s i d e r e d . O u r conclusion is t h a t m o s t likely some e q u i l i b r i u m m o d e l with a *This research was initiated at the University of Chicago where Mehra was a visiting scholar at the Graduate School of Business and Prescott a Ford foundation visiting professor at the Department of Economics. Earlier versions of this paper, entitled 'A Test of theIntertemporal Asset Pricing ModeF, were presented at the University of Minnesota, University of Lausanne, Harvard University, NBER Conference on Intertemporal Puzzles in Macroeconomics, and the American Finance Meetings. We wish to thank the workshop participants, George Coustantinides, Eugene Fama, Merton Miller, and particularly an anonymous referee, Fischer Black, Stephen LeRoy and CharlesPlosser for helpful discussions and constructive criticisms. We gratefully acknowledge financial support from the Faculty Research Fund of the Graduate School of Business, Columbia University, the National Sdence Foundation and the Federal Reserve Bank of Minneapolis. 0304-3923/85/$3.30©1985, Elsevier Science Publishers B.V. (North-Holland)
R. Mehra and E.C Prescott, The equitypremiumfriction will be the one that successfully accounts for the large average equity premium. We study a class of competitive pure exchange economies for which the equilibrium growth rate process on consumption and equilibrium asset returns are stationary. Attention is restricted to economies for which the elasticity of substitution for the composite consumption good between the year t and year t + 1is consistent with findings in micro, macro and international economics. In addition, the economies are constructed to display equilibrium consumption growth rates with the same mean, variance and serial correlation as those observed for the U.S. economy in the 1889-1978 period. We find that for such economies, the average real annual yield on equity is a maximum of four-tenths of a percent higherthan that on short-term debt, in sharp contrast to the six percent premium observed. Our results are robust to non-stationarities in the means and variances of the economies' growth processes. The simple class of economies studied, we think, is well suited for the question posed. It clearly is poorly suited for other issues, in particular issues such as the volatility of asset prices. 1 We...