Researchers in the area of finance have recently documented predictable movements in stock prices and in risk premiums (rates of return above risk-free interest rates) on stocks and bonds, and found that these predictable movements correlate strongly with business cycles. However, a number of important questions remain unanswered including: What causes these predictable movements? Why are they correlated with business cycles? What do these facts tell us about the behavior of stock markets and about business cycles? The theoretical framework in which these questions are currently addressed stresses the link between stock returns and consumption. Basically, it pays people to defer consumption purchases and invest in the market when stock returns are expected to be high. However, consumption barely changes over the business cycle. The significant changes occur with respect to employment, investment, inventories, and production. The purpose of this project is to exploit the theoretical link between stock and bond returns and producers, and develop a model which links stock and bond returns to the important business cycle variables mentioned above. The recently documented, predictable movements in stock returns have already been used to argue that the stock market is "inefficient" or that it overreacts to small events and rumors, and that, hence, regulatory changes are needed. But, at this point we do not know what kind of predictable movements in stock prices actually do make sense within the context of a well functioning market and, thus, it is impossible to assess the validity of this argument. This project is important because it will shed some light on this issue.
