Economic Activity of Firms and Asset Prices

In this review we survey the recent research on the fundamental determinants of stock returns. These studies explore how firms' systematic risk and their investment and production decisions are jointly determined in equilibrium. Models with production provide insights into several types of empirical patterns, including (a) the correlations between firms' economic characteristics and their risk premia, (b) the comovement of stock returns among firms with similar characteristics, and (c) the joint dynamics of asset returns and macroeconomic quantities. Moreover, by explicitly relating firms' stock returns and cash flows to fundamental shocks, models with production connect the analysis of financial markets with the research on the origins of macroeconomic fluctuations

An algorithm to solve heterogenous agent models with aggregate uncertainty

General equilibrium models with heterogeneous agents are very difficult to solve because the wealth distribution, a multidimensional and infinite object, must be part of the state space. Krussell and Smith propose a numerical solution where the wealth distribution is summarized by its first moment. However, the volatility of equity in their model is unrealistically low. I show that markets do not clear in a model with more realistic volatility if the wealth distribution is summarized by its first moment only. I propose an alternate algorithm where the wealth distribution is summarized by a finite set of probability density functions which come from simulating the model. This algorithm can solve both the Krussell and Smith model, as well the more volatile version