MACROECONOMIC VOLATILITY AND THE EQUITY PREMIUM

Recent empirical work documents a decline in the U.S. equity premium and a decline in the standard deviation of real output growth.We investigate the link between aggregate risk and the asset returns in a dynamic production based asset-pricing model.When calibrated to match asset return moments, the model implies that the post-1984 reduction in TFP shock volatility of 60 percent gives rise to a 40 percent decline in the equity premium.Lower macroeconomic risk post-1984 can account for a substantial fraction of the decline in the equity premium.