Bridging the Classroom Gap between Asset Pricing and Business Cycle Theory

Abstract

The tools presented in the standard undergraduate economics and finance curricula are insufficient for explaining the complex dynamics of the modern U.S. economy. For instance, students of macroeconomics are not provided with a satisfactory framework for assessing how a financial shock may reverberate through the real economy, as it did during the Great Recession of 2008-2009. Similarly, students of finance are left with little guidance as to the origins of two key inputs into asset pricing models, namely cash flows and discount rates. In this article we present a unified macro-financial model to bridge the gap between the typical undergraduate treatments of asset pricing and business cycle theory. The Dynamic Empirical Macroeconomic (DyEM) model we introduce here offers several innovations, the most important of which is expanding the role of the interest rate to include term and default risk premia. We combine these elements to construct a series of discount rates that are critical for a range of present discounted value calculations. Moreover, we link economic activity to earnings growth in order to facilitate macro-based equity pricing. The paper concludes with an illustration of how the DyEM model may be used in the classroom via a cooperative learning exercise centered on the Great Recession.