The equity premium and the business cycle: the role of demand and supply shocks

We examine the relation between US stock market returns and the US business cycle for the period 1960 - 2003 using a new methodology that allows us to analyse the different effects of aggregate demand and supply shocks. Previous empirical evidence, which is based on the relation between stock returns and their volatility, is shown to be limited by it’s use of the CAPM and not the more general SDF approach to asset pricing. Our main findings are that historically negative supply shocks have been the most important source of increases in the equity risk premium and demand shocks have been much less important. The model is implemented using a multivariate GARCH-in-mean model with an asymmetric time-varying conditional heteroskedasticity and correlation structure.