Asset pricing lessons for modeling business cycles

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Abstract
We develop a model which accounts for the observed equity premium and average risk-free rate, without implying counterfactually high risk aversion. The model also does well in accounting for business-cycle phenomena. With respect to the conventional measures of business-cycle volatility and comovement with output, the model does roughly as well as the standard business-cycle model. On two other dimensions, the model?s business-cycle implications are actually improved. Its enhanced internal propagation allows it to account for the fact that there is positive persistence in output growth, and the model also provides a resolution to the ?excess sensitivity puzzle? for consumption and income. Two key features of the model are habit persistence preferences and a multisector technology with limited intersectoral mobility of factors of production.

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