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Risk Aversion and the Labor Margin in Dynamic Equilibrium Models

  • Eric T. Swanson

The household's labor margin has a substantial effect on risk aversion, and hence asset prices, in dynamic equilibrium models even when utility is additively separable between consumption and labor. This paper derives simple, closed-form expressions for risk aversion that take into account the household's labor margin. Ignoring this margin can dramatically overstate the household's true aversion to risk. Risk premia on assets priced with the stochastic discount factor increase essentially linearly with risk aversion, so measuring risk aversion correctly is crucial for asset pricing in the model.

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File URL: http://www.aeaweb.org/articles.php?doi=10.1257/aer.102.4.1663
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Article provided by American Economic Association in its journal American Economic Review.

Volume (Year): 102 (2012)
Issue (Month): 4 (June)
Pages: 1663-91

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Handle: RePEc:aea:aecrev:v:102:y:2012:i:4:p:1663-91
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  1. Merton, Robert C, 1973. "An Intertemporal Capital Asset Pricing Model," Econometrica, Econometric Society, vol. 41(5), pages 867-87, September.
  2. Ricardo Lagos & Randall Wright, 2002. "A unified framework for monetary theory and policy analysis," Working Paper 0211, Federal Reserve Bank of Cleveland.
  3. Kihlstrom, Richard E. & Mirman, Leonard J., 1974. "Risk aversion with many commodities," Journal of Economic Theory, Elsevier, vol. 8(3), pages 361-388, July.
  4. Boldrin, Michele & Christiano, Lawrence J. & Fisher, Jonas D.M., 1997. "Habit Persistence And Asset Returns In An Exchange Economy," Macroeconomic Dynamics, Cambridge University Press, vol. 1(02), pages 312-332, June.
  5. Jermann, Urban J., 1998. "Asset pricing in production economies," Journal of Monetary Economics, Elsevier, vol. 41(2), pages 257-275, April.
  6. Alvarez, Fernando & Stokey, Nancy L., 1998. "Dynamic Programming with Homogeneous Functions," Journal of Economic Theory, Elsevier, vol. 82(1), pages 167-189, September.
  7. Stiglitz, Joseph E, 1969. "Behavior Towards Risk with Many Commodities," Econometrica, Econometric Society, vol. 37(4), pages 660-67, October.
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