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1 Introduction The behavior of aggregate stock prices is a subject of enduring fascination to investors,pol- icymakers,and economists.In recent years stock markets have continued to show some fa- miliar patterns,including high average returns and volatile and procyclical price movements. Economists have struggled to understand these patterns.If stock prices are determined by fundamentals,then what exactly are these fundamentals and what is the mechanism by which they move prices? Researchers,working primarily with US data,have documented a host of interesting styl- ized facts about the stock market and its relation to short-term interest rates and aggregate consumption. 1.The average real return on stock is high.In quarterly US data over the period 1947.2 to 1998.4,a standard data set that is used throughout this chapter,the average real stock return has been 8.1%at an annual rate.2 2.The average riskless real interest rate is low.3-month Treasury bills deliver a return that is riskless in nominal terms and close to riskless in real terms because there is only modest uncertainty about inflation at a 3-month horizon.In the postwar quarterly US data,the average real return on 3-month Treasury bills has been 0.9%per year. 3.Real stock returns are volatile,with an annualized standard deviation of 15.6%in the US data. 4.The real interest rate is much less volatile.The annualized standard deviation of the ex post real return on US Treasury bills is 1.7%,and much of this is due to short-run inflation risk.Less than half the variance of the real bill return is forecastable,so the standard deviation of the ex ante real interest rate is considerably smaller than 1.7%. 2Here and throughout the chapter,the word return is used to mean a log or continuously compounded return unless otherwise stated.Thus the average return corresponds to a geometric average,which is lower than the arithmetic average of simple returns. 1 %% % ( , % # ) ( # - ( ( ) # % % % . %% - ( # ' / 0 # (% !" # % ) ( ( ) %% % % ( % - $ !" 123 1142# % # % ( 45 % ( 6) ( ( 7 6) - $ !" # % 6) 15 6 0 ( # 895 !" 2 ' !" 35# ) 7 ( : # ' 35 - - - - - = + + + - = 2- - =-- += - - - +