Scandinavian Working Papers in Economics

Seminar Papers,
Stockholm University, Institute for International Economic Studies

No 729: Social Security and the Equity Premium Puzzle

Conny Olovsson ()
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Conny Olovsson: Institute for International Economic Studies, Stockholm University, Postal: Stockholm University, S-106 69 Stockholm, Sweden

Abstract: This paper shows that social security may be an important factor in explaining the equity premium puzzle. In the absence of shortselling constraints, the young shortsell bonds to the middle-aged and buy equity. Social security reduces the bond demand of the middle-aged, thereby restricting the possibilities of the young to finance their equity purchases. They demand less equity and the return to equity goes up. Social security also increases the covariance between future consumption and the equity income of the young. The efect on the equity premium is substantial. In fact, a model with social security and borrowing constraints can generate a fairly realistic equity premium.

Keywords: Asset prices; the equity premium puzzle; social security

JEL-codes: G12; H55

23 pages, March 16, 2004

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