PRELIMINARY DO NOT CITE OR CIRCULATE Equity Premia with Benchmark Levels of Consumption, Leverage, Imperfect Correlation of Consumption and Dividends, and Distorted Beliefs: Closed-Form Results∗

xxxabstract ∗The paper was prepared as a chapter in Rajnish Mehra and Edward Prescott (eds.), Handbook of Investments: Equity Risk Premium. Mehra and Prescott (1985) showed that over a period of almost a cen-tury, the equity premium—the excess of the rate of return on stocks over the rate of return on riskless bills—averaged 6.18 % per year. They then cali-brated a general equilibrium asset-pricing model of the sort introduced by Lucas (1978) and showed that such a model, with conventional values of the coefficient of relative risk aversion, cannot come close to accounting for the historically observed equity premium. In the two decades since Mehra and Prescott proclaimed an equity premium puzzle, a large body of research has been devoted to closing the gap between theoretical asset-pricing mod-els and empirically observed asset returns. The seminal study by Mehra and Prescott used a simple general equilibrium model with a representativ