Replicating Business Cycles and Asset Returns with Sentiment and Low Risk Aversion

Using a real business cycle model, I solve for the sequences of shocks (or wedges) that allow the model to exactly replicate the quarterly time paths of U.S. macroeconomic variables and asset returns since 1960. Shocks that appear in the capital law of motion and shocks to equity sentiment are important drivers of movements in most U.S. variables and asset returns. But other shocks also play a significant role, particularly for lower frequency movements. The results imply that there is no "most important shock." Rather, U.S. economic outcomes have been shaped by a complex and time-varying mixture of fundamental and non-fundamental disturbances