The Return to Capital and the Business Cycle

Real business cycle models have difficulty replicating the volatility of Samp;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 Samp;P 500 returns. The standard business cycle model captures almost 40% 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% of the relative volatility in the return to capital