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A Parsimonious Macroeconomic Model for Asset Pricing

  • Fatih Guvenen

I study asset prices in a two-agent macroeconomic model with two key features: limited stock market participation and heterogeneity in the elasticity of intertemporal substitution in consumption (EIS). The model is consistent with some prominent features of asset prices, such as a high equity premium, relatively smooth interest rates, procyclical stock prices, and countercyclical variation in the equity premium, its volatility, and in the Sharpe ratio. In this model, the risk-free asset market plays a central role by allowing non-stockholders (with low EIS) to smooth the fluctuations in their labor income. This process concentrates non-stockholders' labor income risk among a small group of stockholders, who then demand a high premium for bearing the aggregate equity risk. Furthermore, this mechanism is consistent with the very small share of aggregate wealth held by non-stockholders in the U.S. data, which has proved problematic for previous models with limited participation. I show that this large wealth inequality is also important for the model's ability to generate a countercyclical equity premium. When it comes to business cycle performance, the model's progress has been more limited: consumption is still too volatile compared to the data, whereas investment is still too smooth. These are important areas for potential improvement in this framework. Copyright 2009 The Econometric Society.

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Article provided by Econometric Society in its journal Econometrica.

Volume (Year): 77 (2009)
Issue (Month): 6 (November)
Pages: 1711-1750

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Handle: RePEc:ecm:emetrp:v:77:y:2009:i:6:p:1711-1750
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