Equity Premium: Interaction of Belief Heterogeneity and Distribution of Wealth?

Introducing heterogeneity of beliefs across different agents builds a link between wealth distribution and the equity premium. We demonstrate that an economy populated only by risk neutral agents may nonetheless display a strictly positive equity premium. We then place our notion of belief heterogeneity within the popular representative agent construct. We show that any level of belief heterogeneity in the multi agent economy can be mapped into some specific degree of risk aversion of the representative agent economy that keeps equilibrium prices constant. A fully dynamic model follows. Finally, we suggest an explanation for the recent behavior of the equity premium: a story of "heterogeneous optimism" versus "homogeneous pessimism" is presented.