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Asset Pricing, Growth, And The Business Cycle With Irreversible Investment

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  • Miquel Faig

Abstract

This paper advances a simple model that emphasizes the diversity of capital types, some of these types are long lived, while others are highly specific. This modeling of capital implies that irreversibility constraints may be strongly binding, thus generating sizable capital losses, even with moderate shocks and positive aggregate investment. The resulting riskiness of investing in capital has consequences for growth, the business cycle, and asset returns. Growth is affected as the representative consumer invests a larger portion of output as a form of self-insurance. The business cycle is affected as consumption becomes more variable. The asset returns are affected as the added risk raises its premium, specially in recessions. The focus of the paper is to evaluate the quantitative importance of these effects. When evaluated, the model is capable of matching the most prominent characteristics of U.S. output, consumption, and asset returns, including a wide equity premium. However, this is not a resolution to the equity premium puzzle as the paper does not address why the representative consumer has the high risk aversion necessary to match these observed time series.

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File URL: http://www.economics.utoronto.ca/public/workingPapers/UT-ECIPA-FAIG-98-02.pdf
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Bibliographic Info

Paper provided by University of Toronto, Department of Economics in its series Working Papers with number faig-98-02.

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Length: 26 pages
Date of creation: 11 Sep 1999
Date of revision:
Handle: RePEc:tor:tecipa:faig-98-02

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  1. Faig, Miquel, 2001. "Understanding Investment Irreversibility in General Equilibrium," Economic Inquiry, Western Economic Association International, vol. 39(4), pages 499-510, October.
  2. Beaudry, Paul & Guay, Alain, 1996. "What do interest rates reveal about the functioning of real business cycle models?," Journal of Economic Dynamics and Control, Elsevier, vol. 20(9-10), pages 1661-1682.
  3. Lawrence J. Christiano & Jonas Fisher, 1995. "Tobin's q and Asset Returns: Implications for Business Cycle Analysis," NBER Working Papers 5292, National Bureau of Economic Research, Inc.
  4. Weil, Philippe, 1989. "The equity premium puzzle and the risk-free rate puzzle," Journal of Monetary Economics, Elsevier, vol. 24(3), pages 401-421, November.
  5. Michele Boldrin & Lawrence J. Christiano & Jonas D.M. Fisher, 1995. "Asset pricing lessons for modeling business cycles," Working Paper Series, Macroeconomic Issues 95-11, Federal Reserve Bank of Chicago.
  6. R. Mehra & E. Prescott, 2010. "The equity premium: a puzzle," Levine's Working Paper Archive 1401, David K. Levine.
  7. John Y. Campbell & John H. Cochrane, 1994. "By force of habit: a consumption-based explanation of aggregate stock market behavior," Working Papers 94-17, Federal Reserve Bank of Philadelphia.
  8. TallariniJr., Thomas D., 2000. "Risk-sensitive real business cycles," Journal of Monetary Economics, Elsevier, vol. 45(3), pages 507-532, June.
  9. Robert J. Barro, 1988. "Government Spending in a Simple Model of Endogenous Growth," NBER Working Papers 2588, National Bureau of Economic Research, Inc.
  10. Ramey, Valerie A & SHAPIRO, MATTHEW D, 1998. "Displaced Capital," University of California at San Diego, Economics Working Paper Series qt49k7n14z, Department of Economics, UC San Diego.
  11. Ramey, Valerie A. & Shapiro, Matthew D., 1998. "Costly capital reallocation and the effects of government spending," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 48(1), pages 145-194, June.
  12. Sargent, Thomas J., 1980. ""Tobin's q" and the rate of investment in general equilibrium," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 12(1), pages 107-154, January.
  13. Fama, Eugene F & French, Kenneth R, 1988. "Permanent and Temporary Components of Stock Prices," Journal of Political Economy, University of Chicago Press, vol. 96(2), pages 246-73, April.
  14. Lawrence J. Christiano & Jonas D.M. Fisher, 1997. "Algorithms for solving dynamic models with occasionally binding constraints," Working Paper 9711, Federal Reserve Bank of Cleveland.
  15. Ferson, Wayne E & Harvey, Campbell R, 1991. "The Variation of Economic Risk Premiums," Journal of Political Economy, University of Chicago Press, vol. 99(2), pages 385-415, April.
  16. Dow, J.P.J. & Olson, L.J., 1990. ""Irreversibility and the Behavior of Aggregate Stochastic Growth Models"," The A. Gary Anderson Graduate School of Management 90-10, The A. Gary Anderson Graduate School of Management. University of California Riverside.
  17. Narayana R. Kocherlakota, 1996. "The Equity Premium: It's Still a Puzzle," Journal of Economic Literature, American Economic Association, vol. 34(1), pages 42-71, March.
  18. Michael J. Boskin, 1998. "Consumer Prices, the Consumer Price Index, and the Cost of Living," Journal of Economic Perspectives, American Economic Association, vol. 12(1), pages 3-26, Winter.
  19. Marcelo Veracierto, 1997. "Plant level irreversible investment and equilibrium business cycles," Discussion Paper / Institute for Empirical Macroeconomics 115, Federal Reserve Bank of Minneapolis.
  20. Olson, Lars J., 1989. "Stochastic growth with irreversible investment," Journal of Economic Theory, Elsevier, vol. 47(1), pages 101-129, February.
  21. 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.
  22. Stephen G. Cecchetti & Pok-sang Lam & Nelson C. Mark, 1988. "Mean Reversion in Equilibrium Asset Prices," NBER Working Papers 2762, National Bureau of Economic Research, Inc.
  23. Constantinides,George & Duffie,Darrel, 1992. "Asset pricing with heterogeneous consumers," Discussion Paper Serie A 381, University of Bonn, Germany.
  24. Coleman Ii, Wilbur John, 1997. "Behavior Of Interest Rates In A General Equilibrium Multisector Model With Irreversible Investment," Macroeconomic Dynamics, Cambridge University Press, vol. 1(01), pages 206-227, January.
  25. Cochrane, John H, 1996. "A Cross-Sectional Test of an Investment-Based Asset Pricing Model," Journal of Political Economy, University of Chicago Press, vol. 104(3), pages 572-621, June.
  26. Kjetil Storesletten & Chris Telmer & Amir Yaron, . "Persistent Idiosyncratic Shocks and Incomplete Markets," GSIA Working Papers 24, Carnegie Mellon University, Tepper School of Business.
  27. Jermann, Urban J., 1998. "Asset pricing in production economies," Journal of Monetary Economics, Elsevier, vol. 41(2), pages 257-275, April.
  28. John Y. Campbell & John Cochrane, 1999. "Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior," Journal of Political Economy, University of Chicago Press, vol. 107(2), pages 205-251, April.
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