154 R.Mehra and E.C.Prescott,The equity premium assume two states for the Markov chain and to restrict the process as follows: 入1=1+4+6，入2=1+4-8， φ11=中22=中， φ12=中21=(1-中) The parameters u,,and 6 now define the technology.We require 8>0 and 0<<1.This particular parameterization was selected because it permitted us to independently vary the average growth rate of output by changing u,the variability of consumption by altering 6,and the serial correlation of growth rates by adjustingφ. The parameters were selected so that the average growth rate of per capita consumption,the standard deviation of the growth rate of per capita consump- tion and the first-order serial correlation of this growth rate,all with respect to the model's stationary distribution,matched the sample values for the U.S. economy between 1889-1978.The sample values for the U.S.economy were 0.018,0.036 and -0.14,respectively.The resulting parameter's values were u=0.018,8=0.036 and =0.43.Given these values,the nature of the test is to search for parameters a and B for which the model's averaged risk-free rate and equity risk premium match those observed for the U.S.economy over this ninety-year period. The parameter a,which measures peoples'willingness to substitute con- sumption between successive yearly time periods is an important one in many fields of economics.Arrow (1971)summarizes a number of studies and concludes that relative risk aversion with respect to wealth is almost constant. He further argues on theoretical grounds that a should be approximately one. Friend and Blume (1975)present evidence based upon the portfolio holdings of individuals that a is larger,with their estimates being in the range of two. Kydland and Prescott (1982),in their study of aggregate fluctuations,found that they needed a value between one and two to mimic the observed relative variabilities of consumption and investment.Altug (1983),using a closely related model and formal econometric techniques,estimates the parameter to be near zero.Kehoe (1984),studying the response of small countries balance of trade to terms of trade shocks,obtained estimates near one,the value posited by Arrow.Hildreth and Knowles (1982)in their study of the behavior of farmers also obtain estimates between one and two.Tobin and Dolde (1971), studying life cycle savings behavior with borrowing constraints,use a value of 1.5 to fit the observed life cycle savings patterns. Any of the above cited studies can be challenged on a number of grounds but together they constitute an a priori justification for restricting the value of a to be a maximum of ten,as we do in this study.This is an important restriction,for with large a virtually any pair of average equity and risk-free returns can be obtained by making small changes in the process on consump-