The excess volatility puzzle (Shiller, 1981, and LeRoy and Porter, 1981) and the equity premium puzzle (Mehra and Prescott, 1985) are two fundamental challenges to theoretical models that have been developed in the finance and macroeconomics literature. Building a production economy model that would satisfactorily account for both high aggregate stock market volatility and the behavior of aggregate quantities has proven to be difficult and no consensus model has arisen. In this paper we build a model in which variations in firms’ ability to raise external capital to take profitable projects lead to asset price volatility. We calibrate the model to the U.S. data and find that it generates about 80% of the observed aggregate stock market volatility. At the same time, the model generates time-series properties of aggregate quantities that match the macroeconomic data.

Our model closely resembles the model described in Kiyotaki and Moore (2008). It is a dynamic stochastic general equilibrium model with heterogeneous entrepreneurs, who face a real and a financial friction. The real friction restricts entrepreneurs’ access to new projects. In every period only a fraction of entrepreneurs find new profitable projects. Following the literature, we assume that the arrival of profitable projects is i.i.d. over time and over entrepreneurs, see e.g. Angeletos (2007) and Kocherlakota (2009). We model an entrepreneur’s ability to start a profitable project as his ability to produce new capital goods one-to-one from the general consumption good. Entrepreneurs who cannot produce capital are willing to buy claims to returns of other entrepreneurs’ projects to replace their depreciated capital. We call these claims equity. Markets are incomplete and equity is the only financial asset that is traded in the economy. The financial friction restricts new issuance of equity. We assume that entrepreneurs can only leverage a fraction of the returns of the newly produced capital, i.e. sell only a fraction of the new project as equity. On its own, this friction is standard in the literature. The novel feature of our model is that the ratio of outside to total financing of projects changes over time.