Non-falsified expectations and general equilibrium asset pricing: The power of the peso

We discuss the extent to which the expectation of a rare event which happens not to materialise over the sample period, but which is not rationally excludable from the set of possibilities - the peso problem -, can affect the behaviour of rational agents and the characteristics of market equilibrium. To that end we describe quantitatively the macroeconomic and financial properties of a standard equilibrium business cycle model modified to allow for a very small probability of a depression state. We produce a model specification for which both business cycle characteristics and mean financial returns are in accord with United States observations.