The equity premium in a production economy; A new perspective involving recursive utility

Knut Aase

No 2015/15, Discussion Papers from Norwegian School of Economics, Department of Business and Management Science

Abstract: We study a rational expectations' competitive equilibrium in a production economy, i.e., a system of prices at which firms' profit maximizing production decisions and individuals' preferred affordable consumption choices equate supply and demand in every market. We derive the equilibrium price of the firm and the equilibrium short term interest rate, the optimal per capita consumption in society, as well as the risk premium on equity. First a simple linear production technology with constant coefficients is studied, then a more general technology, and finally a general production economy with recursive utility is analyzed by the use of the stochastic maximum principle. While the two first models can not explain the empirics well using conventional preferences, the latter model is found to be much more promising in this regard. Wa also demonstrate a simple proof for the ICAPM.

Keywords: Equity risk premium; production economy; recursive utility; CAPM; CCAPM; ICAPM (search for similar items in EconPapers)
JEL-codes: D51 D53 D90 E21 G10 G12 (search for similar items in EconPapers)
Pages: 47 pages
Date: 2015-04-10
New Economics Papers: this item is included in nep-mac and nep-upt
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