Ambiguity Aversion, the Equity Premium and the Welfare Costs of Business Cycles
AbstractWe 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 InfoPaper provided by Stockholm University, Institute for International Economic Studies in its series Seminar Papers with number 752.
Length: 36 pages
Date of creation: 06 Aug 2007
Date of revision:
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Postal: Institute for International Economic Studies, Stockholm University, S-106 91 Stockholm, Sweden
Web page: http://www.iies.su.se/
More information through EDIRC
Ambiguity aversion; asset prices; business cycle;
Find related papers by JEL classification:
- D14 - Microeconomics - - Household Behavior - - - Household Saving; Personal Finance
- E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
- G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
This paper has been announced in the following NEP Reports:
- NEP-ALL-2007-08-14 (All new papers)
- NEP-BEC-2007-08-14 (Business Economics)
- NEP-DGE-2007-08-14 (Dynamic General Equilibrium)
- NEP-MAC-2007-08-14 (Macroeconomics)
- NEP-UPT-2007-08-14 (Utility Models & Prospect Theory)
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