We analyze how changes in government policy affect stock prices. Our general equilibrium model features uncertainty about government policy and a government whose decisions have both economic and noneconomic motives. The model makes numerous empirical predictions. Stock prices should fall at the announcement of a policy change, on average. The price decline should be large if uncertainty about government policy is large, and also if the policy change is preceded by a short or shallow economic downturn. Policy changes should increase volatilities and correlations among stocks. The jump risk premium associated with policy decisions should be positive, on average.

We develop a model of political cycles driven by time-varying risk aversion. Agents choose to work in the public or private sector and to vote Democrat or Republican. 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 and risk aversion declines during Democratic presidencies. Public workers vote Democrat while entrepreneurs vote Republican, as the model predicts.