The return to capital and the business cycle

A widely cited failing of real business cycle models is their inability to account for the cyclical patterns of financial variables. Perhaps less well known is the fact that the returns to capital and equity are identical in the neoclassical growth model. This paper constructs a measure of the return to business capital for the U.S. The S&P 500 return is roughly six times more volatile than the return to business capital. Owing to the equivalence between the returns to capital and equity in the neoclassical growth model, papers in the real business cycle literature that successfully account for the time series variation in the S&P 500 return must fail to account for the time series properties of the return to capital. A fairly basic real business cycle model captures most of the observed variability in the return to capital. What is needed is a theory of the stock market that breaks the equivalence between the returns to equity and capital.

Research highlights► The paper establishes an equivalence between return to capital and return to equity. ► The return to capital is measured using National Income and Product Accounts; its standard deviation is 6 times smaller than that of the S&P 500 return. ► It is shown that a real business cycle model with stochastic taxes and stochastic relative price of investment goods accounts for almost all of the volatility in the return to capital.