State-dependent preferences can explain the equity premium puzzle

Abstract

We introduce state-dependent recursive preferences into the Mehra-Prescott economy. We show that such preferences can match the historical first two moments of the returns on equity and the risk-free rate. Other authors have reported similar results using state-dependent expected utility preferences. These authors have tended to emphasize the importance of countercyclical risk aversion in explaining the equity premium puzzle. We find that countercyclical risk aversion plays an important role but only when combined with modest cyclical variation in intertemporal substitution. © 2003 Elsevier Inc. All rights reserved.