DP1884 Inspecting the Mechanism: The Determination of Asset Prices in the Real Business Cycle Model

Author(s): Martin Lettau
Publication Date: May 1998
Keyword(s): analytical solution, Asset Prices, loglinear approximation, RBC model, Risk Premia
JEL(s): E13, G12
Programme Areas: International Macroeconomics, Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=1884

In this paper, we derive closed-form solutions for a variety of prices for financial assets in an RBC economy. The equations are based on a loglinear solution of the RBC model and allow a clearer understanding of the determination of risk premia in models with production. E.g., we show that risk premia of long real bonds and equity are negative when technology shocks are permanent. Moreover, the wedge between the equity premium and the long bond premium is small and often negative. The closed-form solutions presented here are applicable to any RBC model that can be approximated in loglinear form.