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Ambiguity Aversion, the Equity Premium and the Welfare Costs of Business Cycles

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  • Alonso, Irasema

    ()
    (Yale University)

  • Prado, Jr., Jose Mauricio

    (Institute for International Economic Studies, Stockholm University)

Abstract

We examine the potential importance of consumer ambiguity aversion for asset prices and how consumption ‡fluctuations influence consumer welfare. First, considering a simple Mehra-Prescott-style endowment economy with a representative agent facing consumption fluctuations calibrated to match U.S. data, we study to what extent ambiguity aversion can deliver asset prices that are consistent with data: a high return on equity and a low return on riskfree bonds. For some configurations of preference parameters— a discount factor, a degree of relative risk aversion, and a measure of ambiguity aversion— we find that it can. Then, we use these parameter configurations to investigate how much consumers would be willing to pay to reduce endowment fluctuations to zero, thus delivering a Lucas-style welfare cost of fluctuations. These costs turn out to be very large: consumers are willing to pay over 10% of consumption in permanent terms.

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Bibliographic Info

Paper provided by Stockholm University, Institute for International Economic Studies in its series Seminar Papers with number 752.

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Length: 36 pages
Date of creation: 06 Aug 2007
Date of revision:
Handle: RePEc:hhs:iiessp:0752

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Postal: Institute for International Economic Studies, Stockholm University, S-106 91 Stockholm, Sweden
Phone: +46-8-162000
Fax: +46-8-161443
Web page: http://www.iies.su.se/
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Keywords: Ambiguity aversion; asset prices; business cycle;

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  1. Robert E. Lucas Jr. & Nancy L. Stokey, 1982. "Optimal Growth with Many Consumers," Discussion Papers 518, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
  2. repec:cup:macdyn:v:8:y:2004:i:5:p:617-32 is not listed on IDEAS
  3. Epstein, Larry G & Wang, Tan, 1994. "Intertemporal Asset Pricing Under Knightian Uncertainty," Econometrica, Econometric Society, vol. 62(2), pages 283-322, March.
  4. Larry Epstein & Martin Schneider, 2005. "Ambiguity, Information Quality and Asset Pricing," RCER Working Papers 519, University of Rochester - Center for Economic Research (RCER).
  5. R. Mehra & E. Prescott, 2010. "The equity premium: a puzzle," Levine's Working Paper Archive 1401, David K. Levine.
  6. Larry G. Epstein & Martin Schneider, 2001. "Recursive Multiple-Priors," RCER Working Papers 485, University of Rochester - Center for Economic Research (RCER).
  7. Robert E. Lucas Jr., 2003. "Macroeconomic Priorities," American Economic Review, American Economic Association, vol. 93(1), pages 1-14, March.
  8. Coen-Pirani, Daniele, 2004. "Effects Of Differences In Risk Aversion On The Distribution Of Wealth," Macroeconomic Dynamics, Cambridge University Press, vol. 8(05), pages 617-632, November.
  9. David Schmeidler, 1989. "Subjective Probability and Expected Utility without Additivity," Levine's Working Paper Archive 7662, David K. Levine.
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