Carlstrom and Fuerst meets Epstein and Zin: The Asset Pricing Implications of Contracting Frictions

Joao Gomes Ram Yamarthy Amir Yaron∗

March 2015

Abstract

Models with financial frictions have been shown to create amplification and persistence effects in macroeconomic fluctuations. We test the ability that Costly State Verification (CSV) has to generate empirically plausible risk exposures in asset markets, when households have Epstein and Zin (1989) preferences and productivity shocks are in the style of Long Run Risks. Under the setup of Carlstrom and Fuerst (1997), alongside these mechanisms, we find that the CSV friction is negligible in augmenting the aggregate equity premium. Additionally we find that the separation between the elasticity of intertemporal substitution and risk aversion plays a key role in explaining financial market dynamics; in particular, we are only able to generate sizable equity premium when the elasticity is greater than one. Moreover, while the contracting friction provides volatility to the price of capital, its contribution is not significant. Instead physical adjustment costs of capital are much more meaningful in reaching realistic quantitative targets.