Journal of Monetary Economics 15 (1985) 145-161. North-Holland

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 bills are 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. Introduction
H 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 a n 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 t for 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 the