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Long-Run Risk through Consumption Smoothing

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  • Georg Kaltenbrunner

    (London Business School)

  • Lars Lochstoer

    (London Business School)

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    Abstract

    We show that a standard production economy model where consumers have Epstein-Zin preferences can jointly explain the low volatility of consumption growth and a high market price of risk with a low coefficient of relative risk aversion (5). Endogenous consumption smoothing increases the price of risk in this economy as it induces highly persistent time-variation in expected aggregate consumption growth (long-run risk), even though technology follows a random walk. As is usual in production economy models, the volatility of equity returns is quite low. We propose an extension where we calibrate the wage process to the data and show that this brings the equity volatility, and thus the equity premium, much closer to historical values. The model identifies an observable proxy for otherwise hard to measure expected consumption growth. Using this proxy, we test and find support for key predictions of our model in the time-series of consumption growth and the cross-section of stock returns.

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    Bibliographic Info

    Paper provided by Society for Economic Dynamics in its series 2007 Meeting Papers with number 25.

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    Date of creation: 2007
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    Handle: RePEc:red:sed007:25

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    1. Fernando Restoy & G. Michael Rockinger, 1993. "On Stock Market Returns and Returns on Investments," Banco de Espa�a Working Papers 9311, Banco de Espa�a.
    2. Ravi Bansal & Amir Yaron, 2000. "Risks for the Long Run: A Potential Resolution of Asset Pricing Puzzles," NBER Working Papers 8059, National Bureau of Economic Research, Inc.
    3. Garey Ramey & Wouter J. den Haan & Joel Watson, 2000. "Job Destruction and Propagation of Shocks," American Economic Review, American Economic Association, vol. 90(3), pages 482-498, June.
    4. Long, John B, Jr & Plosser, Charles I, 1983. "Real Business Cycles," Journal of Political Economy, University of Chicago Press, vol. 91(1), pages 39-69, February.
    5. John Y. Campbell, 1992. "Inspecting the Mechanism: An Analytical Approach to the Stochastic Growth Model," NBER Working Papers 4188, National Bureau of Economic Research, Inc.
    6. Milton Friedman, 1957. "A Theory of the Consumption Function," NBER Books, National Bureau of Economic Research, Inc, number frie57-1, July.
    7. Hall, Robert E, 1978. "Stochastic Implications of the Life Cycle-Permanent Income Hypothesis: Theory and Evidence," Journal of Political Economy, University of Chicago Press, vol. 86(6), pages 971-87, December.
    8. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
    9. David K. Backus & Stanley E. Zin, 1994. "Reverse Engineering the Yield Curve," NBER Working Papers 4676, National Bureau of Economic Research, Inc.
    10. Motohiro Yogo, 2006. "A Consumption-Based Explanation of Expected Stock Returns," Journal of Finance, American Finance Association, vol. 61(2), pages 539-580, 04.
    11. Epstein, Larry G & Zin, Stanley E, 1989. "Substitution, Risk Aversion, and the Temporal Behavior of Consumption and Asset Returns: A Theoretical Framework," Econometrica, Econometric Society, vol. 57(4), pages 937-69, July.
    12. Nicolae B. Gârleanu & Stavros Panageas & Jianfeng Yu, 2009. "Technological Growth and Asset Pricing," NBER Working Papers 15340, National Bureau of Economic Research, Inc.
    13. Thomas Tallarini, . "Risk-Sensitive Real Business Cycles," GSIA Working Papers 1997-35, Carnegie Mellon University, Tepper School of Business.
    14. Robert B. Barsky & J. Bradford De Long, 1992. "Why Does the Stock Market Fluctuate?," NBER Working Papers 3995, National Bureau of Economic Research, Inc.
    15. Valkanov, Rossen, 2003. "Long-horizon regressions: theoretical results and applications," Journal of Financial Economics, Elsevier, vol. 68(2), pages 201-232, May.
    16. Jermann, Urban J., 1998. "Asset pricing in production economies," Journal of Monetary Economics, Elsevier, vol. 41(2), pages 257-275, April.
    17. Milton Friedman, 1957. "Introduction to "A Theory of the Consumption Function"," NBER Chapters, in: A Theory of the Consumption Function, pages 1-6 National Bureau of Economic Research, Inc.
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    Cited by:
    1. François Gourio, 2009. "Disasters Risk and Business Cycles," NBER Working Papers 15399, National Bureau of Economic Research, Inc.

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