Abstract
We estimate agents’ expectations about future fundamentals using a dynamic stochastic general equilibrium model augmented with anticipated shocks. Accounting for agents’ expectations at the business cycle horizon results in aggregate risk factor innovations that have significant explanatory power for the cross section of stock and bond returns. Further, risk arising from macroeconomic fluctuations driven by expectation shocks is important to explain the value premium. Overall, expectations emerge as key to the link between financial markets and the real economy.
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