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The 6D Bias and the Equity-Premium Puzzle

In: NBER Macroeconomics Annual 2001, Volume 16

  • Xavier Gabaix
  • David Laibson

If decision costs lead agents to update consumption every D periods, then econometricians will find an anomalously low correlation between equity returns and consumption growth (Lynch 1996). We analytically characterize the dynamic properties of an economy composed of consumers who have such delayed updating. In our setting, an econometrician using an Euler equation procedure would infer a coefficient of relative risk aversion biased up by a factor of 6D. Hence with quarterly data, if agents adjust their consumption every D = 4 quarters, the imputed coefficient of relative risk aversion will be 24 times greater than the true value. High levels of risk aversion implied by the equity premium and violations of the Hansen-Jagannathan bounds cease to be puzzles. The neoclassical model with delayed adjustment explains the consumption behavior of shareholders. Once limited participation is taken into account, the model matches most properties of aggregate consumption and equity returns, including new evidence that the covariance between ln(Ct+h/Ct) and Rt+1 slowly rises with h.

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This chapter was published in:
  • Ben S. Bernanke & Kenneth Rogoff, 2002. "NBER Macroeconomics Annual 2001, Volume 16," NBER Books, National Bureau of Economic Research, Inc, number bern02-1, December.
  • This item is provided by National Bureau of Economic Research, Inc in its series NBER Chapters with number 11067.
    Handle: RePEc:nbr:nberch:11067
    Contact details of provider: Postal: National Bureau of Economic Research, 1050 Massachusetts Avenue Cambridge, MA 02138, U.S.A.
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