Series: Working Papers. 2635.
Author: Pierlauro Lopez, Francisco Vázquez-Grande and David López-Salido
Business investment
- Interest rates
- Quantitative methods
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Abstract
A simple production economy with nominal price rigidities explains several key asset pricing facts, including the average slopes and cyclicality of equity and interest rate term structures. Nominal rigidities amplify the procyclicality of dividends after negative productivity shocks and generate countercyclical inflation, as sluggish price adjustment leads to a gradual dividend recovery. Consequently, short-duration equities (bonds) have more (less) procyclical payoffs than their long-duration counterparts. Slow-moving consumption habits produce large, countercyclical risk prices, yielding realistic asset valuations. Extending Campbell-Cochrane preferences with both market and home consumption habits allows them to operate in production economies while preserving realistic macroeconomic dynamics.