ASSET PRICING, GROWTH, AND THE BUSINESS CYCLE WITH IRREVERSIBLE INVESTMENT

This paper advances a simple model that emphasizes the diversity of capital types, some of these types are long lived, while others are highly specific. This modeling of capital implies that irreversibility constraints may be strongly binding, thus generating sizable capital losses, even with moderate shocks and positive aggregate investment. The resulting riskiness of investing in capital has consequences for growth, the business cycle, and asset returns. Growth is affected as the representative consumer invests a larger portion of output as a form of self-insurance. The business cycle is affected as consumption becomes more variable. The asset returns are affected as the added risk raises its premium, specially in recessions. The focus of the paper is to evaluate the quantitative importance of these effects. When evaluated, the model is capable of matching the most prominent characteristics of U.S. output, consumption, and asset returns, including a wide equity premium. However, this is not a resolution to the equity premium puzzle as the paper does not address why the representative consumer has the high risk aversion necessary to match these observed time series.