CHAPTER 7

Financial Markets and the Real

Economy
John H. Cochrane∗
University of Chicago

1. Introduction 239
1.1. Risk Premia 239
1.2. Who Cares? 242
1.3. The Mimicking Portfolio Theorem and the Division of Labor 243
2. Facts: Time Variation and Business Cycle Correlation of Expected Returns 244
2.1. Variation over Time 244
2.2. Variation Across Assets 245
2.3. Return Forecasts—Variation over Time 246
2.4. The Cross Section of Returns—Variation Across Assets 251
3. Equity Premium 257
3.1. Mehra and Prescott and the Puzzle 261
3.2. The Future of the Equity Premium 266
4. Consumption Models 267
4.1. Hansen and Singleton; Power Utility 267
4.2. New Utility Functions 270
4.3. Empirics with New Utility Functions 273
4.4. Consumption and Factor Models 286
5. Production, Investment, and General Equilibrium 290
5.1. “Production-Based Asset Pricing” 290
5.2. General Equilibrium 294

∗ Thisis a substantially reworked version of two papers that appeard under the same title, Cochrane (2005b,
2006a). I gratefully acknowledge research support from the NSF in a grant administered by the NBER and
from the CRSP. I thank Ron Balvers, Frederico Belo, John Campbell, George Constantinides, Hugo Garduno,
François Gourio, Robert Ditmar, Lars Hansen, John Heaton, Hanno Lustig, Rajnish Mehra, Marcus Opp,
Dino Palazzo, Monika Piazzesi, Nick Roussanov, Alsdair Scott, Luis Viceira, Mike Wickens, and Motohiro
Yogo for comments.

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