DP11864-2 | Political Cycles and Stock Returns

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We develop a model of political cycles driven by time-varying risk aversion. Heterogeneous agents make two choices: whether to work in the public or private sector and which of two political parties to vote for. In equilibrium, when risk aversion is high, agents elect Democrats---the party promising more redistribution. The model predicts higher average stock market returns under Democratic presidencies, explaining the well-known ``presidential puzzle." The model can also explain why economic growth has been faster under Democratic presidencies. In the data, Democratic voters are more risk-averse. Public workers vote Democrat while entrepreneurs vote Republican, as the model predicts.