Abstract
This research investigates a link between capital market imperfections and asset pricing in a dynamic general equilibrium framework. Capital market imperfections are modeled in the form of investment frictions in a version of the costly state verification model, which is then embedded in a standard real business cycle model to study the effects of such frictions on the behavior of asset returns as well as on the business cycle dynamics. This paper shows how the severity of the frictions in capital markets may increase the volatility of the return on equity. Investment frictions in this model constrain the firm's ability to change its investment plan for intertemporal capital accumulation, which leads to lower variability in investment and higher variability in the price of capital. Consequently, the more severe the frictions, the more volatile is the return on capital, implying that holding equity of the firm is riskier and that the risk-free asset is relatively more valuable, and thereby generating a higher equity premium.
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