Abstract

The data-generating process of productivity growth includes both trend and business-cycle shocks, generating many counterfactuals for prices under full-information. In practice, agents cannot immediately distinguish between the two shocks, leading to “rational confusion”: each shock inherits properties of its counterpart. This confusion magnifies the perceived share of permanent shocks and implies that, in contrast to canonical frameworks, transitory shocks are the main driver of long-run risk through trendy business-cycles. With learning, the equity premium turns positive, and both investment and valuation ratios become procyclical, in-line with the data. Consequently, rational confusion is key for bridging disciplined macro-dynamics with equilibrium asset-prices.

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• Keyword(s):
• asset pricing 28
• finance 247

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