September 1999 ASSET PRICING, GROWTH, AND THE BUSINESS CYCLE WITH IRREVERSIBLE INVESTMENT

This paper advances a simple model that emphasizes the diversity of capital types, some of which are long lived, while others are highly specific. This modeling of capital implies that irreversibility constraints may be strongly binding, thus generating sizable and undiversifiable capital losses, even with moderate shocks and positive aggregate investment. The resulting riskiness of investing in capital has consequences for growth, the business cycle, and asset returns. Growth is affected since the representative consumer invests a larger portion of output as a form of self-insurance. The business cycle is affected since consumption becomes more variable. The asset returns are affected since the added risk raises its premium, especially in recessions. The focus of the paper is to evaluate the quantitative importance of these effects. When evaluated, the model is capable of matching the most prominent characteristics of U.S. output, consumption, and asset returns, including a wide equity premium. However, this is not a resolution to the equity premium puzzle because the paper does not address why the representative consumer has the high risk aversion necessary to match these observed time series. Portions of this paper were previously circulated as part of the manuscript "Investment Irreversibility in * General Equilibrium: Capital Accumulation, Interest Rates, and the Risk Premium." I thank J. Coleman, N. Kocherlakota, J. Floyd, A. Hynes, A. Melino, T. McCurdy, J. Pesando, M. Veracierto, M. Wooders, X. Zhu, the members of the Money-Macro Workshop of the University of Toronto, and the participants in the NBER Monetary Program Meeting (April 1997), the AEA Meeting (January 1998), and an anonymous referee for their comments. I am also grateful to V. Chari for encouraging me to present this material in its present form. Finally, I am indebted to the assistance of S. Laszlo. As usual, 2 any shortcomings are my responsibility.