18 them,despite of their very low rates of return). To return to the original question:are stocks that much riskier than T-bills so as to justify a six percentage differential in their rates of return? What came as a surprise to many economists and researchers in finance was the conclu- sion of a paper by Mehra and Prescott,written in 1979.Stocks and bonds pay off in approxi- mately the same states of nature or economic scenarios and hence,as argued earlier,they should command approximately the same rate of return.In fact,using standard theory to estimate risk- adjusted returns,we found that stocks on average should command,at most,a one percent return premium over bills.Since,for as long as we had reliable data (about 100 years),the mean pre- mium on stocks over bills was considerably and consistently higher,we realized that we had a puzzle on our hands.It took us six more years to convince a skeptical profession and for our pa- per "The Equity Premium:A Puzzle"to be published.(Mehra and Prescott(1985)). 2.1 Standard Preferences The neoclassical growth model and its stochastic variants are a central construct in con- temporary finance,public finance,and business cycle theory.It has been used extensively by, among others,Abel et al.(1989),Auerbach and Kotlikoff(1987),Barro and Becker(1988). Brock(1979),Cox,Ingersoll and Ross(1985),Donaldson and Mehra(1984),Lucas(1978), Kydland and Prescott(1982),and Merton(1971).In fact,much of our economic intuition is de- rived from this model class.A key idea of this framework is that consumption today and con- sumption in some future period are treated as different goods.Relative prices of these different goods are equal to people's willingness to substitute between these goods and businesses'ability to transform these goods into each other.18 them, despite of their very low rates of return). To return to the original question: are stocks that much riskier than T-bills so as to justify a six percentage differential in their rates of return? What came as a surprise to many economists and researchers in finance was the conclu￾sion of a paper by Mehra and Prescott, written in 1979. Stocks and bonds pay off in approxi￾mately the same states of nature or economic scenarios and hence, as argued earlier, they should command approximately the same rate of return. In fact, using standard theory to estimate risk￾adjusted returns, we found that stocks on average should command, at most, a one percent return premium over bills. Since, for as long as we had reliable data (about 100 years), the mean pre￾mium on stocks over bills was considerably and consistently higher, we realized that we had a puzzle on our hands. It took us six more years to convince a skeptical profession and for our pa￾per “The Equity Premium: A Puzzle” to be published. (Mehra and Prescott (1985)). 2.1 Standard Preferences The neoclassical growth model and its stochastic variants are a central construct in con￾temporary finance, public finance, and business cycle theory. It has been used extensively by, among others, Abel et al. (1989), Auerbach and Kotlikoff (1987), Barro and Becker (1988), Brock (1979), Cox, Ingersoll and Ross (1985), Donaldson and Mehra (1984), Lucas (1978), Kydland and Prescott (1982), and Merton (1971). In fact, much of our economic intuition is de￾rived from this model class. A key idea of this framework is that consumption today and con￾sumption in some future period are treated as different goods. Relative prices of these different goods are equal to people’s willingness to substitute between these goods and businesses’ ability to transform these goods into each other