Year: 2003
Type: article
Abstract: Mehra and Prescott (1985) found the difference between average equity and debt returns puzzling because it was too large to be a premium for bearing nondiversifiable aggregate risk.Here, we re-examine this puzzle, taking into account some factors ignored by Mehra and Prescott-taxes, regulatory constraints, and diversification costs-and focusing on long-term rather than short-term savings instruments.Accounting for these factors, we find the difference between average equity and debt returns during peacetime in the last century is less than 1 percent, with the average real equity return somewhat under 5 percent, and the average real debt return almost 4 percent.As theory predicts, the real return on debt has been close to the 4 percent average after-tax real return on capital.Similarly, as theory predicts, the real return on equity is equal to the after-tax real return on capital plus a modest premium for bearing nondiversifiable aggregate risk.
Source: American Economic Review
Authors: Ellen R McGrattan, Edward C Prescott
Institutions: University of Minnesota, Federal Reserve Bank of Minneapolis
Language: English
Subfield: Finance
Domain: Social Sciences
Open Access status: green
OpenAlex ID: W2155886504