Habit Formation: A Resolution of the Equity Premium Puzzle
AbstractThe equity premium puzzle, identified by Rajnish Mehra and Edward C. Prescott, states that, for plausible values of the risk aversion coefficient, the difference of the expected rate of return on the stock market and the riskless rate of interest is too large, given the observed small variance of the growth rate in per capita consumption. The puzzle is resolved in the context of an economy with rational expectations once the time separability of von Neumann-Morgenstern preferences is relaxed to allow for adjacent complementarity in consumption, a property known as habit persistence. Essentially, habit persistence drives a wedge between the relative risk aversion of the representative agent and the intertemporal elasticity of substitution in consumption. Copyright 1990 by University of Chicago Press.
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Bibliographic InfoArticle provided by University of Chicago Press in its journal Journal of Political Economy.
Volume (Year): 98 (1990)
Issue (Month): 3 (June)
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Other versions of this item:
- G. Constantinides, 1990. "Habit formation: a resolution of the equity premium puzzle," Levine's Working Paper Archive 1397, David K. Levine.
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- Scheinkman, Jose A & Weiss, Laurence, 1986. "Borrowing Constraints and Aggregate Economic Activity," Econometrica, Econometric Society, vol. 54(1), pages 23-45, January.
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