The Equity Premium and the Financial Accelerator

This paper investigates the ampli cation mechanism of the nancial accelerator on the equity premium in a production economy. To accomplish this, I incorporate the Gertler and Karadi (2011) type nancial accelerator into a medium-scale New Keynesian model with generalized recursive preferences. I nd that the nancial accelerator is a very plausible and new ampli cation mechanism for risk premia in the model. For the baseline calibration, the nancial accelerator increases the equity premium by 46 basis points and produces fourfold greater response to shocks than the modelimplied equity premium without nancial frictions. I also show two channels by which the nancial accelerator a ects the equity premium. The rst channel increases the variability of the stochastic discount factor, and the second channel a ects interest rates and in ation through the Taylor rule and marginal cost, respectively. Finally, increasing the adjustment costs of investment does not improve the asset pricing performance in the model. JEL classi cation: E32, E44, G12