Inspecting the mechanism: closed-form solutions for asset prices in real business cycle models

In this paper we derive closed-form solutions for a variety of prices for financial assets in an RBC economy. The equations are based on a log-linear solution of the RBC model and allow a clearer understanding of the determination of risk premia in models with production. We demonstrate not only why the premium of equity over the risk-free rate is small but also why the premium of equity over a real long-term bond is small and often negative. In particular, risk premia for equity and long real bonds are negative when technology shocks are permanent. The closed-form solutions presented here are applicable to any RBC model that can be approximated in log-linear form.