Habit persistence, asset returns, and the business cycle

Two modifications are introduced into the standard real-business-cycle mode l: habit preferences and a two-sector technology with limited intersectoral factor mobility. The model is consistent with the observed mean risk-free rate, equity premium, and Sharpe ratio on equity. In addition, its business -cycle implications represent a substantial improvement over the standard m odel. It accounts for persistence in output, comovement of employment acros s different sectors over the business cycle, the evidence of "excess sensit ivity" of consumption growth to output growth, and the "inverted leading-in dicator property of interest rates," that interest rates are negatively cor related with future output.