Abstract
Under power utility, a high risk premium implies that the risk-free rate is volatile and that price-dividend ratios fall on good news about future economic growth rates. I show how a simple modification of standard power utility can solve these problems. In the model, individuals evaluate consumption relative to expected consumption. This specification separates risk aversion from reaction to news, since the benchmark moves endogenously with new information about future consumption. I derive exact closed-form solutions for the case of log-linear growth rates. The model is able to match the empirical risk premium and the level and volatility of the risk-free rate.
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