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The 6D Bias and the Equity-Premium Puzzle

In: NBER Macroeconomics Annual 2001, Volume 16

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  • Xavier Gabaix
  • David Laibson

Abstract

If decision costs lead agents to update consumption every D periods, then econometricians will find an anomalously low correlation between equity returns and consumption growth (Lynch 1996). We analytically characterize the dynamic properties of an economy composed of consumers who have such delayed updating. In our setting, an econometrician using an Euler equation procedure would infer a coefficient of relative risk aversion biased up by a factor of 6D. Hence with quarterly data, if agents adjust their consumption every D = 4 quarters, the imputed coefficient of relative risk aversion will be 24 times greater than the true value. High levels of risk aversion implied by the equity premium and violations of the Hansen-Jagannathan bounds cease to be puzzles. The neoclassical model with delayed adjustment explains the consumption behavior of shareholders. Once limited participation is taken into account, the model matches most properties of aggregate consumption and equity returns, including new evidence that the covariance between ln(Ct+h/Ct) and Rt+1 slowly rises with h.

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This chapter was published in:

  • Ben S. Bernanke & Kenneth Rogoff, 2002. "NBER Macroeconomics Annual 2001, Volume 16," NBER Books, National Bureau of Economic Research, Inc, number bern02-1, July.
    This item is provided by National Bureau of Economic Research, Inc in its series NBER Chapters with number 11067.

    Handle: RePEc:nbr:nberch:11067

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    1. John Y. Campbell, 1998. "Asset Prices, Consumption, and the Business Cycle," NBER Working Papers 6485, National Bureau of Economic Research, Inc.
    2. John H. Cochrane & Lars Peter Hansen, 1992. "Asset Pricing Explorations for Macroeconomics," NBER Chapters, National Bureau of Economic Research, Inc, in: NBER Macroeconomics Annual 1992, Volume 7, pages 115-182 National Bureau of Economic Research, Inc.
    3. Lucas, Robert E, Jr, 1978. "Asset Prices in an Exchange Economy," Econometrica, Econometric Society, Econometric Society, vol. 46(6), pages 1429-45, November.
    4. Weil, Philippe, 1989. "The equity premium puzzle and the risk-free rate puzzle," Journal of Monetary Economics, Elsevier, Elsevier, vol. 24(3), pages 401-421, November.
    5. John H. Cochrane, 1988. "The Sensitivity of Tests of the Intertemporal Allocation of Consumption to Near-Rational Alternatives," NBER Working Papers 2730, National Bureau of Economic Research, Inc.
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    7. Heaton, John & Lucas, Deborah J, 1996. "Evaluating the Effects of Incomplete Markets on Risk Sharing and Asset Pricing," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 104(3), pages 443-87, June.
    8. Hansen, Lars Peter & Singleton, Kenneth J, 1983. "Stochastic Consumption, Risk Aversion, and the Temporal Behavior of Asset Returns," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 91(2), pages 249-65, April.
    9. Luttmer, Erzo G J, 1996. "Asset Pricing in Economies with Frictions," Econometrica, Econometric Society, Econometric Society, vol. 64(6), pages 1439-67, November.
    10. Hua He and David M. Modest., 1992. "Market Frictions and Consumption-Based Asset Pricing," Research Program in Finance Working Papers, University of California at Berkeley RPF-223, University of California at Berkeley.
    11. Sanford J. Grossman & Guy Laroque, 1987. "Asset Pricing and Optimal Portfolio Choice in the Presence of Illiquid Durable Consumption Goods," NBER Working Papers 2369, National Bureau of Economic Research, Inc.
    12. Nicholas Barberis & Ming Huang & Tano Santos, 2001. "Prospect Theory And Asset Prices," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 116(1), pages 1-53, February.
    13. Fischer, Stanley, 1977. "Long-Term Contracts, Rational Expectations, and the Optimal Money Supply Rule," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 85(1), pages 191-205, February.
    14. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, Elsevier, vol. 12(3), pages 383-398, September.
    15. Benartzi, Shlomo & Thaler, Richard H, 1995. "Myopic Loss Aversion and the Equity Premium Puzzle," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 110(1), pages 73-92, February.
    16. Hall, Robert E, 1978. "Stochastic Implications of the Life Cycle-Permanent Income Hypothesis: Theory and Evidence," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 86(6), pages 971-87, December.
    17. Arthur B. Kennickell & Martha Starr-McCluer & Brian J. Surette, 2000. "Recent changes in U. S. family finances: results from the 1998 Survey of Consumer Finances," Federal Reserve Bulletin, Board of Governors of the Federal Reserve System (U.S.), Board of Governors of the Federal Reserve System (U.S.), issue Jan, pages 1-29.
    18. David I. Laibson & Xavier Gabaix, 2000. "A Boundedly Rational Decision Algorithm," American Economic Review, American Economic Association, American Economic Association, vol. 90(2), pages 433-438, May.
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