# 97-038/2 (1997-03-15)

Stephen G. Cecchetti, The Ohio State University; Pok-sang Lam, The Ohio State University; Nelson C. Mark, The Ohio State University

We study a Lucas asset pricing model that is standard in all respects, except that therepresentative agent's subjective beliefs about the endowment growth are distorted. Usingconstant-relative-risk-aversion (CRRA) utility, with a CRRA coefficient below ten, andfluctuating beliefs that exhibit, on average, excessive pessimism over expansions and excessiveoptimism over contractions, our model is able to match the first and second moments of theequity premium and risk-free rate, as well as the persistence and predictability of excess returnsfound in the data.