Journal of Monetary Economics 15(1985)145-161.North-Holland THE EQUITY PREMIUM A Puzzle* Rajnish MEHRA Columbia University,New York,NY 10027,USA Edward C.PRESCOTT Federal Reserve Bank of Minneapolis University of Minnesota,Minneapolis,MN 55455,USA. Restrictions that a class of general equilibrium models place upon the average returns of equity and Treasury bills are found to be strongly violated by the U.S.data in the 1889-1978 period.This result is robust to model specification and measurement problems.We conclude that,most likely, an equilibrium model which is not an Arrow-Debreu economy will be the one that simultaneously rationalizes both historically observed large average equity return and the small average risk-free return. 1.Introduction Historically the average return on equity has far exceeded the average return on short-term virtually default-free debt.Over the ninety-year period 1889-1978 the average real annual yield on the Standard and Poor 500 Index was seven percent,while the average yield on short-term debt was less than one percent. The question addressed in this paper is whether this large differential in average yields can be accounted for by models that abstract from transactions costs,liquidity constraints and other frictions absent in the Arrow-Debreu set-up.Our finding is that it cannot be,at least not for the class of economies considered.Our conclusion is that most likely some equilibrium model with a *This research was initiated at the University of Chicago where Mehra was a visiting scholar at the Graduate School of Business and Prescott a Ford foundation visiting professor at the Department of Economics.Earlier versions of this paper,entitled 'A Test of the Intertemporal Asset Pricing Model',were presented at the University of Minnesota,University of Lausanne, Harvard University,NBER Conference on Intertemporal Puzzles in Macroeconomics,and the American Finance Meetings.We wish to thank the workshop participants,George Constantinides, Eugene Fama,Merton Miller,and particularly an anonymous referee,Fischer Black,Stephen LeRoy and Charles Plosser for helpful discussions and constructive criticisms.We gratefully acknowledge financial support from the Faculty Research Fund of the Graduate School of Business,Columbia University,the National Science Foundation and the Federal Reserve Bank of Minneapolis. 0304-3923/85/$3.301985,Elsevier Science Publishers B.V.(North-Holland)