Asset Pricing in Production Economies with Extrapolative Expectations*

Introducing extrapolation bias into a standard one-sector production-based real business cycle model with recursive preferences reconciles salient stylized facts about business cycles (low consumption volatility and high investment volatility relative to output) and financial markets (high equity premium, volatile stock returns, and a low and smooth riskfree rate) with low relative risk aversion and an intertemporal elasticity of substitution in preferences of greater than one. Furthermore, the model matches several conditional stylized facts, such as return predictability based upon dividend yield, Q, and investment rates. These successes derive from the interaction of capital adjustment costs, extrapolative bias, and recursive preferences. Extrapolative bias increases the variation in the wealth-consumption ratio; recursive preferences cause this variation to be strongly priced; and adjustment costs make corporate payouts more procyclical. We provide empirical support for the mechanism of the model. JEL Classification: G02, G12, G14, E30