Working paper series // Federal Reserve Bank of Boston 05-7
We construct a life-cycle model that delivers realistic behavior for both equity holdings and borrowings. The key model ingredient is a wedge between the cost of borrowing and the risk-free investment return. Borrowing can either raise or lower equity demand, depending on the cost of borrowing. A borrowing rate equal to the expected return on equity - which we show roughly matches the data - minimizes the demand for equity. Alternative models with no borrowing or limited borrowing at the risk-free rate cannot simultaneously fit empirical evidence on borrowing and equity holdings.