Abstract
We develop a production based asset pricing model with financially constrained firms to explain the observed high equity premium and low risk-free rate volatility. Investment opportunities are scarce and firms face productivity and liquidity shocks.
A negative liquidity shock forces firms to liquidate a fraction of their assets. We calibrate the model to U.S. data and find that it generates an equity premium and a level and volatility of risk-free rate comparable to those observed in the data.
The model also fits key aspects of the behavior of aggregate quantities, in particular, the volatility of aggregate consumption and investment.