Discussion: Cash Flow Risk, Discounting Risk, and the Equity Premium Puzzle
1. DISCUSSION
Aggregate consumption growth is far too smooth to generate the historically high equity premium with plausible assumptions about risk aversion. This is the equity premium puzzle originally documented in Mehra and Prescott (1985). Accounting for the historically low correlation between equity returns and aggregate consumption growth makes the puzzle worse: only with implausible large risk aversion might one reconcile the observed equity premium. In a growing economy with power utility investors, an implausible large coefficient of risk aversion is not a viable solution for the puzzle because it counterfactually leads ...
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