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

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Author Info
Miquel Faig

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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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Publisher 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
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Handle: RePEc:tor:tecipa:faig-98-02

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Find related papers by JEL classification:
E22 - Macroeconomics and Monetary Economics - - Macroeconomics: Consumption, Saving, Production, Employment, and Investment - - - Capital; Investment; Capacity
G12 - Financial Economics - - General Financial Markets - - - Asset Pricing
O41 - Economic Development, Technological Change, and Growth - - Economic Growth and Aggregate Productivity - - - One, Two, and Multisector Growth Models
E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles

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  2. Constantinides, George M & Duffie, Darrell, 1996. "Asset Pricing with Heterogeneous Consumers," Journal of Political Economy, University of Chicago Press, vol. 104(2), pages 219-40, April. [Downloadable!] (restricted)
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  3. TallariniJr., Thomas D., 2000. "Risk-sensitive real business cycles," Journal of Monetary Economics, Elsevier, vol. 45(3), pages 507-532, June. [Downloadable!] (restricted)
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  5. Kjetil Storesletten & Chris Telmer & Amir Yaron, . "Persistent Idiosyncratic Shocks and Incomplete Markets," GSIA Working Papers 24, Carnegie Mellon University, Tepper School of Business. [Downloadable!]
  6. 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. [Downloadable!] (restricted)
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  8. 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. [Downloadable!]
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  10. 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. [Downloadable!] (restricted)
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  15. Miquel Faig, 1998. "Understanding Investment Irreversibility In General Equilibrium," Working Papers faig-98-01, University of Toronto, Department of Economics. [Downloadable!]
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  16. Dow, James Jr. & Olson, Lars J., 1992. "Irreversibility and the behavior of aggregate stochastic growth models," Journal of Economic Dynamics and Control, Elsevier, vol. 16(2), pages 207-223, April. [Downloadable!] (restricted)
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  17. Marcelo Veracierto, 1997. "Plant level irreversible investment and equilibrium business cycles," Discussion Paper / Institute for Empirical Macroeconomics 115, Federal Reserve Bank of Minneapolis. [Downloadable!]
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  18. Lawrence J. Christiano & Jonas D.M. Fisher, 1994. "Algorithms for solving dynamic models with occasionally binding constraints," Working Paper Series, Macroeconomic Issues 94-6, Federal Reserve Bank of Chicago.
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  19. 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. [Downloadable!] (restricted)
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  22. Barro, Robert J, 1990. "Government Spending in a Simple Model of Endogenous Growth," Journal of Political Economy, University of Chicago Press, vol. 98(5), pages S103-26, October. [Downloadable!] (restricted)
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  23. 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. [Downloadable!] (restricted)
  24. 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. [Downloadable!] (restricted)
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