Non‐falsified Expectations and General Equilibrium Asset Pricing: The Power of the Peso

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We discuss the extent to which the expectation of a rare event which happens not to materialise over the sample period, but which is not rationally excludable from the set of possibilities – the peso problem –, can affect the behaviour of rational agents and the characteristics of market equilibrium. To that end we describe quantitatively the macroeconomic and financial properties of a standard equilibrium business cycle model modified to allow for a very small probability of a depression state. We produce a model specification for which both business cycle characteristics and mean financial returns are in accord with United States observations.This paper examines the possibility that the large equity premium observed in the United States may result from the expectations of a disaster event, or set of events, which happen not to have materialised in the sample period of observations. Such a possibility, which falls under the rubric of a peso phenomenon, is supported by recent empirical work of Goetzman and Jorion (1997). Using return data for a wide range of countries, these authors conclude that the high historical premium in the United States is unique, and they conjecture that it may be attributable to the fact that disastrous events affecting other financial markets (e.g. WWII for Japan, Germany, and other European countries) have largely bypassed the American economy.