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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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  5. Barro, Robert J., 1990. "Government Spending in a Simple Model of Endogeneous Growth," Scholarly Articles 3451296, Harvard University Department of Economics.
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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.
  9. Phillippe Weil, 1997. "The Equity Premium Puzzle and the Risk-Free Rate Puzzle," Levine's Working Paper Archive 1833, David K. Levine.
  10. 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.
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  17. Jermann, Urban J., 1998. "Asset pricing in production economies," Journal of Monetary Economics, Elsevier, vol. 41(2), pages 257-275, April.
  18. Faig, Miquel, 2001. "Understanding Investment Irreversibility in General Equilibrium," Economic Inquiry, Western Economic Association International, vol. 39(4), pages 499-510, October.
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  20. Narayana R. Kocherlakota, 1995. "The equity premium: it's still a puzzle," Discussion Paper / Institute for Empirical Macroeconomics 102, Federal Reserve Bank of Minneapolis.
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  23. 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.
  24. 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.
  25. Valerie A. Ramey & Matthew D. Shapiro, 1999. "Costly Capital Reallocation and the Effects of Government Spending," NBER Working Papers 6283, National Bureau of Economic Research, Inc.
  26. Constantinides,George & Duffie,Darrel, 1992. "Asset pricing with heterogeneous consumers," Discussion Paper Serie A 381, University of Bonn, Germany.
  27. 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.
  28. 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.
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