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Demographics and the Equity Premium

Abstract

This paper studies the relation between demographics and the equity premium in a dynamic overlapping generations (OLG) equilibrium model. Investors have both labor and investment income. The labor income and the dividend processes are correlated. Investors trade stocks for consumption purposes and to hedge against the risk of their labor income. The per capita stock supply is normalized to unity, and the demographic structure is time varying. In equilibrium, the equity premium is linear in the real per capita stock price, the dividend yield and the dividend payout ratio, but the coefficients of the linear relation are time varying because of demographic change. Proxying the coefficients by linear functions of the change in the share of population in the age range 40-64, we derive a non-linear predictive regression for the equity premium, which is not only significant in the empirical tests using post-1947 data but also improves significantly on previous predictive relations.

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