Asset Pricing Implications in a Production Economy with an Investment Specific Technology Shock

The focus of this paper is to examine the asset pricing implications of a real business cycle model with recursive preferences and an investment specific technology shock. Particularly, in this model, the relative price of capital is subject to a shock and thereby it first increases the efficiency of investment and then improves the expected marginal product of next period's capital. Introduction of investment specific technology shock along with Epstein-Zin-Weil preferences in a dynamic stochastic general equilibrium model is able to generate equity premium and risk free rate, its volatility as well as key macroeconomic facts that are consistent with U.S. data. The model successfully achieves the desired results with reasonable values of intertemporal elasticity of substitution (IES) and relative risk aversion (RRA) parameters that are consistent with empirical evidence