Leverage, time preference and the ‘equity premium puzzle’

Abstract

We re-examine the Mehra and Prescott (1985) model. A combination of the time preference factor greater than one and reasonable leverage ratios in the equity market resolve the 'equity premium puzzle'. Such parameter values can be consistent with finite expected utility and a positive risk-free rate of interest rate. The model performs better for the MP target values than for economically reasonable variations around those values.