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Equity Premium and Consumption Sensitivity When the Consumer- Investor Allows for Unfavorable Circumstances

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  • Gregory C. Chow

    (Princeton University)

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    Abstract

    Introducing one additional element due to possible misfortune to the return of each of two assets in the basic model of Samuelson (Rev.Econom.Statist.51 (1969)239)on optimum portfolio and consumption decisions,this paper resolves both the excess equity premium and the excess consumption sensitivity puzzles.This uni ed treatment provides a framework to study how important state variables will a ect the change in aggregate consumption which is consid- ered unpredictable in one formulation of the permanent income hypothesis.The implications of the theory agree with empirical results reported here and elsewhere.The theoretical framework appears to be simple and powerful as compared with alternative theories to explain the two puzzles.

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    File URL: http://128.118.178.162/eps/mac/papers/0306/0306012.pdf
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    Bibliographic Info

    Paper provided by EconWPA in its series Macroeconomics with number 0306012.

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    Date of creation: 10 Jun 2003
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    Handle: RePEc:wpa:wuwpma:0306012

    Note: Published in Journal of Economic Dynamics &Control 26 (2002) pp 1417-–1429
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    Web page: http://128.118.178.162

    Related research

    Keywords: Optimum consumption and investment; Asset pricing; Consumption sensitivity; Robust control; The Lagrange method;

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    References

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    Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
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    1. Campbell, John Y. & Mankiw, N. Gregory, 1990. "Permanent Income, Current Income, and Consumption," Scholarly Articles 3353762, Harvard University Department of Economics.
    2. repec:fth:calaec:21-98 is not listed on IDEAS
    3. George M. Constantinides & John B. Donaldson & Rajnish Mehra, 2002. "Junior Can'T Borrow: A New Perspective On The Equity Premium Puzzle," The Quarterly Journal of Economics, MIT Press, vol. 117(1), pages 269-296, February.
    4. R. Mehra & E. Prescott, 2010. "The equity premium: a puzzle," Levine's Working Paper Archive 1401, David K. Levine.
    5. Samuelson, Paul A, 1969. "Lifetime Portfolio Selection by Dynamic Stochastic Programming," The Review of Economics and Statistics, MIT Press, vol. 51(3), pages 239-46, August.
    6. Sargent, Thomas J, 1978. "Rational Expectations, Econometric Exogeneity, and Consumption," Journal of Political Economy, University of Chicago Press, vol. 86(4), pages 673-700, August.
    7. Hansen, Lars Peter & Sargent, Thomas J & Tallarini, Thomas D, Jr, 1999. "Robust Permanent Income and Pricing," Review of Economic Studies, Wiley Blackwell, vol. 66(4), pages 873-907, October.
    8. Chow, Gregory C., 1997. "Dynamic Economics: Optimization by the Lagrange Method," OUP Catalogue, Oxford University Press, number 9780195101928.
    9. 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.
    10. Urban J. Jermann & Marianne Baxter, 1999. "Household Production and the Excess Sensitivity of Consumption to Current Income," American Economic Review, American Economic Association, vol. 89(4), pages 902-920, September.
    11. Flavin, Marjorie A, 1981. "The Adjustment of Consumption to Changing Expectations about Future Income," Journal of Political Economy, University of Chicago Press, vol. 89(5), pages 974-1009, October.
    12. Campbell, John Y. & Mankiw, N. Gregory, 1991. "The response of consumption to income : A cross-country investigation," European Economic Review, Elsevier, vol. 35(4), pages 723-756, May.
    13. Merton, Robert C, 1969. "Lifetime Portfolio Selection under Uncertainty: The Continuous-Time Case," The Review of Economics and Statistics, MIT Press, vol. 51(3), pages 247-57, August.
    14. Zhou, Chunsheng, 1999. "Informational Asymmetry and Market Imperfections: Another Solution to the Equity Premium Puzzle," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 34(04), pages 445-464, December.
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