The Return to Capital and the Business Cycle
Real business cycle models have difficulty replicating the volatility of S&P 500 returns. This fact should not be surprising since real business cycle theory suggests that the return to capital should be measured by the return to aggregate market capital, not stock market returns. We construct a quarterly time series of the after-tax return to business capital. Its volatility is considerably smaller than that of S&P 500 returns. Our benchmark model captures almost 40 percent of the volatility in the return to capital (relative to the volatility of output). We consider several departures from the benchmark model; the most promising is one with higher risk aversion, which captures over 60 percent of the relative volatility in the return to capital.
Suggested citation: Gomme, Paul, B. Ravikumar, and Peter C. Rupert, 2006. "The Return to Capital and the Business Cycle," Federal Reserve Bank of Cleveland, Working Paper no. 06-03.