Risk and return in a dynamic general equilibrium model

Abstract

In this paper we examine the relationship between risk and return on productive assets using the intertemporal general equilibrium model of Brock (1982, Asset Prices in a Production Economy, the University of Chicago Press, Chicago, pp. 1-42) as a basis for a simulation study. Current computational techniques are used to solve the growth model of Brock (1979, An Integration of Stochastic Growth and the Theory of Finance - Part I: The Growth Model, Academic Press, New York, pp. 165-192) in order to analyze the underlying financial model. Contrary to recent empirical findings, we find that there is a theoretical basis for the linear relationship between risk and return. This apparent contradiction is due in part to the fact that the dynamic relationship between risk and return depends on the level of output.