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Infinite horizon CAPM equilibrium

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Author Info

  • Michael Magill

    ()
    (Department of Economics, University of Southern California, Los Angeles, CA 90089-0253, USA)

  • Martine Quinzii

    ()
    (Department of Economics, University of California, Davis, CA 95616-8573, USA)

Abstract

This paper derives the equilibrium of an infinite-horizon discrete-time CAPM economy in which agents have discounted expected quadratic utility functions. We show that there is an income stream obtainable by trading on the financial markets which best approximates perfect consumption smoothing (called the {\it least variable income stream} or LVI) such that the equilibrium consumption of each agent is some multiple of the LVI and some share of aggregate output. The welfare of agents is a decreasing function of the lack of consumption smoothing achievable, measured by the distance of the LVI from the perpetuity of one unit of income for ever. If in addition the economy has a Markov structure, the LVI, and hence the equilibrium, can be calculated by dynamic programming. When the model is calibrated to US data a striking prediction emerges: the quasi-irrelevance of the bond market. Infinitely-lived agents achieve almost all their desired consumption smoothing by applying carryover strategies to equity, the proportion of agents' portfolios in bonds rarely exceeding 3%.

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File URL: http://link.springer.de/link/service/journals/00199/papers/0015001/00150103.pdf
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Bibliographic Info

Article provided by Springer in its journal Economic Theory.

Volume (Year): 15 (2000)
Issue (Month): 1 ()
Pages: 103-138

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Handle: RePEc:spr:joecth:v:15:y:2000:i:1:p:103-138

Note: Received: October 16, 1998; revised version: February 8, 1999
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Web page: http://link.springer.de/link/service/journals/00199/index.htm

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Related research

Keywords: CAPM equilibrium; Consumption smoothing; Incomplete markets; Markov economy;

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Cited by:
  1. Felix Kubler & Karl Schmedders, 2000. "Incomplete Markets, Transitory Shocks, and Welfare," Discussion Papers 1285, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
  2. Tom Krebs, 2002. "Recursive Equilibrium in Endigenous Growth Models with Incomplete Markets," Working Papers 2002-30, Brown University, Department of Economics.

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