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Asset pricing lessons for modeling business cycles

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Author Info
Michele Boldrin
Lawrence J. Christiano
Jonas D.M. Fisher

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Abstract

We develop a model which accounts for the observed equity premium and average risk-free rate, without implying counterfactually high risk aversion. The model also does well in accounting for business-cycle phenomena. With respect to the conventional measures of business-cycle volatility and comovement with output, the model does roughly as well as the standard business-cycle model. On two other dimensions, the model’s business-cycle implications are actually improved. Its enhanced internal propagation allows it to account for the fact that there is positive persistence in output growth, and the model also provides a resolution to the “excess sensitivity puzzle” for consumption and income. Two key features of the model are habit persistence preferences and a multisector technology with limited intersectoral mobility of factors of production.

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Paper provided by Federal Reserve Bank of Minneapolis in its series Working Papers with number 560.

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Date of creation: 1995
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Handle: RePEc:fip:fedmwp:560

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Keywords: Capital assets pricing model ; Business cycles;

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  1. Campbell, John Y. & Mankiw, N. Gregory, 1991. "The response of consumption to income : A cross-country investigation," European Economic Review, Elsevier, vol. 35(4), pages 723-756, May. [Downloadable!] (restricted)
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  3. Robert B. Barsky & Miles S. Kimball & F. Thomas Juster & Matthew D. Shapiro, 1997. "Preference Parameters and Behavioral Heterogeneity: An Experimental Approach in the Health and Retirement Survey," NBER Working Papers 5213, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  6. TallariniJr., Thomas D., 2000. "Risk-sensitive real business cycles," Journal of Monetary Economics, Elsevier, vol. 45(3), pages 507-532, June. [Downloadable!] (restricted)
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  7. John Y. Campbell & N. Gregory Mankiw, 1990. "Consumption, Income, and Interest Rates: Reinterpreting the Time Series Evidence," NBER Working Papers 2924, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  8. Kandel, Shmuel & Stambaugh, Robert F., 1991. "Asset returns and intertemporal preferences," Journal of Monetary Economics, Elsevier, vol. 27(1), pages 39-71, February. [Downloadable!] (restricted)
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  9. Robert E. Hall, 1988. "Intertemporal Substitution in Consumption," NBER Working Papers 0720, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  10. Aiyagari, S. Rao & Gertler, Mark, 1991. "Asset returns with transactions costs and uninsured individual risk," Journal of Monetary Economics, Elsevier, vol. 27(3), pages 311-331, June. [Downloadable!] (restricted)
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  11. 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, vol. 91(2), pages 249-65, April. [Downloadable!] (restricted)
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  13. repec:fth:harver:1435 is not listed on IDEAS
  14. Wilcox, David W, 1992. "The Construction of U.S. Consumption Data: Some Facts and Their Implications for Empirical Work," American Economic Review, American Economic Association, vol. 82(4), pages 922-41, September. [Downloadable!] (restricted)
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  17. Charles R. Nelson & Richard Startz, 1988. "Some Further Results on the Exact Small Sample Properties of the Instrumental Variable Estimator," NBER Technical Working Papers 0068, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  18. Benninga, Simon & Protopapadakis, Aris, 1990. "Leverage, time preference and the 'equity premium puzzle'," Journal of Monetary Economics, Elsevier, vol. 25(1), pages 49-58, January. [Downloadable!] (restricted)
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  20. John Y. Campbell & John H. Cochrane, 1994. "By Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior," CRSP working papers 412, Center for Research in Security Prices, Graduate School of Business, University of Chicago. [Downloadable!]
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  21. Judd, Kenneth L., 1992. "Projection methods for solving aggregate growth models," Journal of Economic Theory, Elsevier, vol. 58(2), pages 410-452, December. [Downloadable!] (restricted)
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  22. Heaton, John & Lucas, Deborah, 1992. "The effects of incomplete insurance markets and trading costs in a consumption-based asset pricing model," Journal of Economic Dynamics and Control, Elsevier, vol. 16(3-4), pages 601-620. [Downloadable!] (restricted)
  23. Lawrence J. Christiano & Jonas D.M. Fisher, 1994. "Algorithms for solving dynamic models with occasionally binding constraints," Working Paper Series, Macroeconomic Issues 94-6, Federal Reserve Bank of Chicago.
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  24. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March. [Downloadable!] (restricted)
  25. Marianne Baxter & Urban J. Jermann, 1999. "Household Production and the Excess Sensitivity of Consumption to Current Income," American Economic Review, American Economic Association, vol. 89(4), pages 902-920, September. [Downloadable!] (restricted)
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  26. Jermann, Urban J., 1998. "Asset pricing in production economies," Journal of Monetary Economics, Elsevier, vol. 41(2), pages 257-275, April. [Downloadable!] (restricted)
  27. Heaton, John, 1993. "The Interaction between Time-Nonseparable Preferences and Time Aggregation," Econometrica, Econometric Society, vol. 61(2), pages 353-85, March. [Downloadable!] (restricted)
  28. Timothy Cogley & James M. Nason, 1993. "Output dynamics in real business cycle models," Working Papers in Applied Economic Theory 93-10, Federal Reserve Bank of San Francisco.
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  29. Jean-Pierre DANTHINE & John B. DONALDSON & Rajnish MEHRA, 1992. "The Equity Premium and the Allocation of Income Risk," Cahiers de Recherches Economiques du Département d'Econométrie et d'Economie politique (DEEP) 9203, Université de Lausanne, Faculté des HEC, DEEP.
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  30. Cecchetti, Stephen G. & Lam, Pok-sang & Mark, Nelson C., 1993. "The equity premium and the risk-free rate : Matching the moments," Journal of Monetary Economics, Elsevier, vol. 31(1), pages 21-45, February. [Downloadable!] (restricted)
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  31. Mankiw, N. Gregory, 1986. "The equity premium and the concentration of aggregate shocks," Journal of Financial Economics, Elsevier, vol. 17(1), pages 211-219, September. [Downloadable!] (restricted)
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  32. Ferson, Wayne E. & Constantinides, George M., 1991. "Habit persistence and durability in aggregate consumption: Empirical tests," Journal of Financial Economics, Elsevier, vol. 29(2), pages 199-240, October. [Downloadable!] (restricted)
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  33. John H. Cochrane & Lars Peter Hansen, 1993. "Asset Pricing Explorations for Macroeconomics," NBER Working Papers 4088, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  34. Martin Lettau & Harald Uhlig, 2000. "Can Habit Formation be Reconciled with Business Cycle Facts?," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 3(1), pages 79-99, January. [Downloadable!] (restricted)
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  35. Lawrence J. Christiano & Martin Eichenbaum, 1990. "Current real business cycle theories and aggregate labor market fluctuations," Discussion Paper / Institute for Empirical Macroeconomics 24, Federal Reserve Bank of Minneapolis. [Downloadable!]
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  36. Christiano, Lawrence J., 1988. "Why does inventory investment fluctuate so much?," Journal of Monetary Economics, Elsevier, vol. 21(2-3), pages 247-280. [Downloadable!] (restricted)
  37. Burnside, Craig, 1994. "Hansen-Jagannathan Bounds as Classical Tests of Asset-Pricing Models," Journal of Business & Economic Statistics, American Statistical Association, vol. 12(1), pages 57-79, January.
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  39. Hansen, Lars Peter & Singleton, Kenneth J, 1982. "Generalized Instrumental Variables Estimation of Nonlinear Rational Expectations Models," Econometrica, Econometric Society, vol. 50(5), pages 1269-86, September. [Downloadable!] (restricted)
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