Asset Prices in Business Cycle Analysis

Asset prices are well known to lead the business cycle, yet most modern models generate movements in prices and quantities that are roughly contemporaneous. In US data, for example, equity returns and the short-term interest rate lead GDP growth by one or two quarters, while growth rates of consumption, investment, and employment growth move more or less together with GDP. We show how all of these features can be reproduced in variant of the Kydland-Prescott model with recursive preferences and a predictable component in productivity growth. A loglinear approximation is featured throughout; as a result, interest rates have a linear structure similar to popular affine models.