On the Equity Premium and Volatility Puzzles*

Jinlu Li
(Shawnee State University, Portsmouth, Ohio 45662, USA)

Abstract: In this paper, I adopt an economic equilibrium model utilizing the framework introduced by Mehra and Prescott (1985) when they presented the equity premium puzzle. This model, in the long run and with respect to stationary probabilities, produces results that match the sample values derived from the U.S. economy between 1889 and 1978 as illustrated by the studies performed by Grossman and Shiller (1981), which includes the expected average, standard deviation, and first-order serial correlation of the growth rate of per capita real consumption and the expected returns and standard deviation of equity, risk-free security, and risk premium for equity. Therefore, this model solves the equity premium and volatility puzzle. I also explore the reasons why the equity premium puzzle was caused.

Key words: the constant relative risk aversion class utility function; risk premium; time discount factor; parameters defining preferences; parameters defining technologies; the equity premium and volatility puzzle

JEL code: C53, E22, E47