Equilibrium Business Cycles, Equity Prices, and the Term Structure of Interest Rates∗ Christopher Gust and David López-Salido† Federal Reserve Board Preliminary and Incomplete

We show that a fruitful way to account for prominent business cycle and asset pricing facts consists of introducing segmented markets into an otherwise standard business-cycle model with isoelastic preferences and elastic capital and labor supply. The key feature of our model is that households rebalance their financial portfolio allocations infrequently, as they face a fixed cost of transferring cash across accounts. The model generates reasonable business cycle properties and is consistent with the mean and volatility of the equity premium and risk-free rate, a nominal yield curve that is upward sloping on average, and the high volatility and predictability of excess returns on equity and bonds. In this framework, long-term nominal debt is riskier than short-term debt, because the systematic response of monetary policy to current inflation induces long-run inflation risk, contributing to high and volatile term premia. ∗The views expressed in this paper are solely the responsibility of the authors and should not be interpreted as reflecting the views of the Board of Governors of the Federal Reserve System or of any other person associated with the Federal Reserve System