Explaining bond and equity premium puzzles jointly in a DSGE model

We introduce costly firm-entry a la Bilbiie et al. (2012) into a New Keynesian model with Epstein-Zin preferences and show that it can jointly account for a high mean value of bond and equity premium without compromising the fit of the model to first and second moments of key macroeconomic variables. In the standard New Keynesian model without entry it is easy to generate inflation risks on long-term nominal bonds when placing high coefficient on the output gap in the Taylor rule. Our model is able to generate inflation risks when the coefficient on the output gap is small. In the entry model real risks are lower and inflation risks are ceteris paribus higher than in the standard New Keynesian model without entry due to the appearance of new varieties that help households smooth their consumption better.