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The Case Against Power Utility and a Suggested Alternative: Resurrecting Exponential Utility

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  • Alpanda, Sami
  • Woglom, Geoffrey
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    Abstract

    Utility modeled as a power function is commonly used in the literature despite the fact that it is unbounded and generates asset pricing puzzles. The unboundedness property leads to St. Petersburg paradox issues and indifference to compound gambles, but these problems have largely been ignored. The asset pricing puzzles have been solved by introducing habit formation to the usual power utility. Given these issues, we believe it is time re-examine exponential utility. Exponential utility was abandoned largely because it implies increasing relative risk aversion in a cross-section of individuals and nonstationarity of the aggregate consumption to wealth ratio, contradicting macroeconomic data. We propose an alternative preference specification with exponential utility and relative habit formation. We show that this utility function is bounded, consistent with asset pricing facts, generates near-constant relative risk aversion in a cross-section of individuals and a stationary ratio of aggregate consumption to wealth.

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    Bibliographic Info

    Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 5897.

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    Date of creation: Jul 2007
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    Handle: RePEc:pra:mprapa:5897

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    Keywords: unbounded utility; asset pricing puzzles; habit formation;

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    1. A. Abel, 2010. "Asset prices under habit formation and catching up with the Jones," Levine's Working Paper Archive 1395, David K. Levine.
    2. Phillippe Weil, 1997. "The Equity Premium Puzzle and the Risk-Free Rate Puzzle," Levine's Working Paper Archive 1833, David K. Levine.
    3. Morris A. Davis & Robert F. Martin, 2005. "Housing, house prices, and the equity premium puzzle," Finance and Economics Discussion Series 2005-13, Board of Governors of the Federal Reserve System (U.S.).
    4. Meyer, Donald J. & Meyer, Jack, 2005. "Risk preferences in multi-period consumption models, the equity premium puzzle, and habit formation utility," Journal of Monetary Economics, Elsevier, vol. 52(8), pages 1497-1515, November.
    5. Sundaresan, Suresh M, 1989. "Intertemporally Dependent Preferences and the Volatility of Consumption and Wealth," Review of Financial Studies, Society for Financial Studies, vol. 2(1), pages 73-89.
    6. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
    7. Constantinides, George M, 1990. "Habit Formation: A Resolution of the Equity Premium Puzzle," Journal of Political Economy, University of Chicago Press, vol. 98(3), pages 519-43, June.
    8. Gali, Jordi, 1994. "Keeping Up with the Joneses: Consumption Externalities, Portfolio Choice, and Asset Prices," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 26(1), pages 1-8, February.
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