February 12, 1996 (First draft: May 17, 1995) We examine the equity premium puzzle with the perspective of the theory of Rational Beliefs Equilibrium (RBE) and show that from the perspective of this theory there is no puzzle. In an RBE agents need to be compensated for the endogenously propagated price uncertainty which is not permitted under rational expectations. It is then argued that endogenous uncertainty is the predominant uncertainty of asset returns and its presence provides a natural explanation of the observed premium. Utilizing data on the asset allocation of 63 U.S. mutual funds, we test some empirical implications of the theory of rational beliefs as well as estimate the parameters of risk aversion of mutual fund managers. Our tests show that the predictions of the theory are consistent with the empirical evidence. We then construct a simple two agent model of the U.S. economy in which the agents hold rational beliefs and calibrate it to the empirical experience in accord with the parameters of the Mehra and Prescott (1985) paper. The results of our calculations show that the model predictions fit closely the historical record.
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