Monetary policy and equity premium puzzle in Iran: a practical approach using a Dynamic Stochastic General Equilibrium Model

Zare Joneghani, Sahar; Sahabi, Bahram; Heydari, Hassan; Zolfaghari, Mehdi; Balounejad Nouri, Roozbeh

doi:10.22055/jqe.2025.46523.2618

Monetary policy and equity premium puzzle in Iran: a practical approach using a Dynamic Stochastic General Equilibrium Model

https://doi.org/10.22055/jqe.2025.46523.2618

Volume 23, Issue 1 - Serial Number 88

Vol. 22, No. 3, spring 2025

Spring 2026

Pages 225-261

Quarterly Journal of Quantitative Economics (JQE)

Document Type : Article-Based Dissertations

Authors

sahar zare joneghani ¹

Bahram Sahabi ²

Hassan Heydari ³

Mehdi Zolfaghari ³

roozbeh balounejad nouri ⁴

¹ PhD student in Monetary Economics, Faculty of Management and Economics, Tarbiat Modares University, Tehran, Iran

² Associate Professor of Economics, Faculty of Management and Economics, Tarbiat Modares University, Tehran, Iran.

³ Assistant Professor of Economics, Faculty of Management and Economics, Tarbiat Modares University, Tehran, Iran

⁴ Associate Professor of Economics, Department of Economics, Economic Research Institute, Tehran, Iran.

Abstract

EXTENDED ABSTRACT
INTRODUCTION
One of the most famous puzzles related to the stock market is the equity premium puzzle, which was first introduced by Mehra and Prescott in the framework of the C-CAPM model. This puzzle states that the return of risky assets (stocks) is so high, that high-risk aversion of investors explains it. Investigating the equity premium puzzle is important because it provides a basis for modifying models like C-CAPM that fail when faced with financial data. The purpose of this study is to investigate the equity premium puzzle in Iran. This study, focusing on the relationship between the real and financial sectors (by examining the central bank's behavior in creating the equity premium puzzle), specified a DSGE model in accordance with the conditions of Iran's economy; The specified model is able to examine the equity premium puzzle in Iran by applying technology shocks, government spending, oil income, stock price index, money supply and the effect of these shocks on asset returns and consumption. In this study, it is assumed that the central bank reacts to the output gap and inflation through changes in the money supply growth. The results showed that the positive shocks of technology and stock prices in the middle -run and long-run until reaching steady- state, the positive shock of oil income in the short-run and middle -run and the positive shock of money supply in the short-run with producing a high equity premium, they are able to explain the equity premium puzzle in Iran; This is while the positive shock of government spending cannot explain the equity premium puzzle in Iran by creating a negative equity premium

METHODOLOGY
This study, focusing on the relationship between the real and financial sectors and in order to investigate the behavior of the central bank in creating the equity premium puzzle, has specified a DSGE model in accordance with the conditions of the Iranian economy; The specified model is able to examine the equity premium puzzle in Iran by applying technology shocks, government spending, oil income, stock price index, money supply and the effect of these shocks on assets returns and consumption.
The data used in this study were collected from the first quarter of 1993 to the fourth quarter of 2021 from the website of Central Bank of Iran and Tehran Stock Exchange Organization. The specified DSGE model is finally simulated using MATLAB software and Diner program.

FINDINGS
The results of the study showed that the positive shocks of technology and stock prices in the middle -run and long-run until reaching steady- state, the positive shock of oil income in the short-run and middle -run and the positive shock of money supply in the short-run with producing a high equity premium, they are able to explain the equity premium puzzle in Iran; This is while the positive shock of government spending cannot explain the equity premium puzzle in Iran by creating a negative equity premium

CONCLUSION
The purpose of the present study is to investigate the Equity premium puzzle in Iran. Focusing on the relationship between the real and financial sectors, this study specified a DSGE model in accordance with the conditions of Iran's economy; The results showed that with the application of positive shocks to technology, oil income and stock prices at a higher value of the output gap coefficient (=-1), consumption fluctuations are lower and risk-free asset return fluctuations are higher (lower consumption fluctuations is due to high risk aversion and the existence of consumption habits in people); According to the results, in the amount of the output gap coefficient is high, the positive shocks of technology and stock prices in the middle-run and long-run, the positive shock of oil income in the short-run and middle-run, and the positive shock of money supply in the short-run by creating stock returns which is higher than the risk-free asset yield, they produce a positive equity premium that can explain the equity premium puzzle in Iran; These results agree with the findings of Mehra and Prescott's C-CAPM model. The theory states that the positive equity premium produced by the high risk aversion of investors can be justified, because risk averse investors avoid consumption fluctuations and tend to smooth their consumption with higher fluctuations in labor supply or risk-free asset rates. The positive shock of government spending was not able to explain the equity premium puzzle due to the creation of a negative equity premium.
The present study is associated with 2 policy recommendations: 1- It is to pay attention to structural parameters such as consumption habits and risk aversion because households have better information about the value of these parameters, so policy makers' lack of attention to these parameters may have a negative effect on their policy goals. 2- Although the existence of a high equity premium can be a good incentive to invest in a risky asset compared to a risk-free asset in uncertain conditions. But the existence of a high equity premium can reduce the uncertainty and risk aversion of investors so that they undertake risky behaviors; Therefore, in implementing their economic plans, policy makers should create the least fluctuation in the macro variables and control the uncertainty in the society.

Keywords

Equity Premium Puzzle

Dynamic Stochastic General Equilibrium Model

Optimal Monetary Policy

Subjects

Monetary economics and banking

Ahmadi, L., Emami, K., Torabi, T., & Farzinvash, A. (2025). Comparative comparison of the effect of oil shock on macroeconomic variables in Iran and GCC countries. Quarterly Journal of Quantitative Economics (JQE), 21(4), 1–38. (in Persian).

Amiri, H., Porjavan, A., & Zahedi, M. (2025). Gold, foreign exchange and Bitcoin as hedge or safe haven for stocks: Evidence from Tehran Stock Exchange (TSE) using Smooth Transition Regression (STR) models. Quarterly Journal of Quantitative Economics (JQE), 21(4), 220–272. (in Persian).

Bayat, M., Afshari, Z., & Tavaklian, H. (2015). Monetary policy and aggregate stock price index in the framework of a DSGE model. Journal of Economic Research and Policy, 24(78), 171–206. (in Persian).

Bayat, M. (2016). Monetary policy and total stock price index in the framework of a DSGE model. PhD Thesis, Faculty of Social Sciences and Economics, Al‑Zahra University. (in Persian).

Bahraminia, I., Abolhasani, A., & Ebrahimi, I. (2017). Neo‑Keynesian stochastic dynamic general equilibrium model for Iran’s economy considering the housing sector. Economic Policy Journal, 10(20), 71–102. (in Persian).

Campbell, J. Y., & Cochrane, J. H. (1999). By force of habit: A consumption‑based explanation of aggregate stock market behavior. Journal of Political Economy, 107(2), 205–251.

Campbell, J. Y. (1996). Asset pricing at the millennium. Journal of Finance, 55, 1515–1567.

Dunbar, K., & Owusu‑Amoako, J. (2021). The impact of hedging on risk‑averse agents’ output decisions. Economic Modelling, 104, 105638.

Erfani, A., Abu Nouri, I., & Safari, S. (2017). Investigating the puzzle of stock exchange in Iran: Bivariate GARCH framework and fuzzy nested virtual variables. Doctoral dissertation, Faculty of Economics, Management and Administrative Sciences, Semnan University. (in Persian).

Ebrahimi, M. (2018). Investigating the impact of macroeconomic variables on Iran’s stock market using data mining algorithms. Financial Economics Journal, 13(49), 283–309. (in Persian).

Filis, G., Degiannakis, S., & Floros, C. (2011). Dynamic correlation between stock market and oil prices: The case of oil‑importing and oil‑exporting countries. International Review of Financial Analysis, 20, 152–164.

Fakhrhosseini, F. (2015). A model of real business cycles with habit formation: A solution to the equity premium puzzle. Journal of Economic Modeling, 11(3), 141–169. (in Persian).

Fakhrhosseini, F. (2011). Stochastic dynamic general equilibrium model for monetary trade periods of Iranian economy. Journal of Economic Modeling Research, 3, 1–28. (in Persian).

Faccini, R., Konstantinidi, E., Skiadopoulos, G., & Sarantopoulou‑Chiourea, S. (2018). A new predictor of U.S. real economic activity: The S&P 500 option‑implied risk aversion. Management Science, 65(10), 1–60.

Guderzi Farahani, Y., Arabi, H., & Adeli, A. (2021). Modeling the role of banking risks in the performance of the banking system and macroeconomic variables with the DSGE approach. Econometric Modeling Journal, 6(22), 151–181. (in Persian).

Jones, D. W., Leiby, P. N., & Paik, I. K. (2004). Oil price shocks and the macroeconomy: What has been learned since 1996. The Energy Journal, 25(2), 1–32.

Kavand, H. (2008). Explaining the effects of oil revenues and monetary policies in the form of a real business cycle model for Iran’s economy. PhD Thesis, University of Tehran, Faculty of Economics. (in Persian).

Kaszab, L. (2014). Fiscal policy at the zero lower bound and in macro‑finance models at normal times. PhD Thesis, Cardiff University.

Kaszab, L., & Marsal, A. (2015). Explaining bond and equity premium puzzles jointly in a DSGE model. MNB Working Papers, No. 1.

Keshavarz Haddad, G., & Esfahani, M. (2014). The equity premium puzzle in Tehran Stock Exchange in the framework of random dominance tests. Iran Economic Research Journal, 18(56), 1–40. (in Persian).

Menna, L., & Tirelli, P. (2014). The equity premium in a DSGE model with limited asset market participation. University of Milan‑Bicocca Working Paper No. 286.

Mohammadzadeh, A., Shahiki Tash, M. N., & Roshan, R. (2014). Investigating the equity premium puzzle in the Iranian economy using the GMM estimation method in the S‑CCAPM model. Journal of Financial Science and Securities Analysis, 9(32), 15–34. (in Persian).

Mehra, R., & Prescott, E. C. (2003). The equity premium in retrospect. In G. M. Constantinides, M. Harris, & R. Stulz (Eds.), Handbook of the Economics of Finance. North‑Holland.

Motavaseli, M., Ebrahimi, I., Shahmoradi, A., & Kamijani, A. (2010). Designing a new Keynesian DSGE model for Iran’s economy as an oil‑exporting country. Economic Research Quarterly, 10(4), 5–29. (in Persian).

Martha, L. (2015). Asset price bubbles and monetary policy in a small open economy. Ensayos Sobre Política Económica, 14–78.

Pratt, J. W. (1964). Risk aversion in the small and in the large. Econometrica, 32(1–2), 122–136.

Rapach, D., & Tan, F. (2019). Bayesian estimation of macro‑finance DSGE models with stochastic volatility. SSRN Working Paper 3469356.

Rudebusch, G., & Swanson, E. (2012). The bond premium in a DSGE model with long‑run real and nominal risks. American Economic Journal: Macroeconomics, 4(1), 105–143.

Rodnia, M. (2016). Asset pricing model based on return utility functions: A case study of Iran’s capital market. Doctoral thesis, University of Sistan and Baluchestan. (in Persian).

Sojodi Korabaslu, A., Dai Karimzadeh, S., & Sharifi Renani, H. (2021). Analysis of the shock response of government consumption expenditure impulses on macroeconomic variables (case study: oil and non‑oil developing countries). Journal of Economic Policy Research, 29, 283–311. (in Persian).

Smets, F., & Wouters, R. (2007). Shocks and frictions in US business cycles. American Economic Review, 97(3), 586–606.

Tobin, J. (1958). Liquidity preference as behavior toward risk. Review of Economic Studies, 25(2), 65–86.

Taghipour, A. (2013). Setting up the dynamic stochastic general equilibrium (DSGE) model for Iran’s economy in order to make policies and predict business cycles. (in Persian).

Tavaklian, H. (2012). Investigating the New Keynesian Phillips curve in the framework of a stochastic dynamic general equilibrium model for Iran. Journal of Economic Research, 47(3), 1–22. (in Persian).

Uhlig, H. (1999). A toolkit for analyzing nonlinear dynamic stochastic models easily. In Computational Methods for the Study of Dynamic Economies. Oxford University Press.

Walsh, C. E. (2010). Monetary theory and policy. MIT Press.

Zare Joneghani, S., Sahabi, B., Heydari, H., & Zolfaghari, M. (2023). Does the equity premium puzzle exist in Iran? Iranian Economic Review.

Zainaldini, Sh., Karimi, M. S., & Khanzadi, A. (2018). Investigating the effect of oil price shocks on the performance of the Iranian stock market. Financial Economics Quarterly, 14(50), 145–161. (in Persian).

XML

PDF 1.15 M

Extended Abstract

Full Text in second language