Parameter learning in production economies

Abstract

We examine how parameter learning amplifies the impact of macroeconomic shocks on equity prices and quantities in a standard production economy where a representative agent has Epstein-Zin preferences. An investor observes technology shocks that follow a regime-switching process but does not know the underlying model parameters governing the short-term and long-run perspectives of economic growth. We show that rational belief updating endogenously generates long-run risks that help explain various asset pricing facts, most prominently, dividend yield variance decomposition. The asset pricing implications of endogenous long-run risks depend crucially on the introduction of a procyclical dividend process.