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Campbell and Cochrane meet Melino and Yang: reverse engineering the surplus ratio in a Mehra-Prescott economy

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  • Jim Dolmas

Abstract

The habit model of Campbell and Cochrane (1999) specifies a process for the 'surplus ratio'-the excess of consumption over habit, relative to consumption-rather than an evolution for the habit stock. It's not immediately apparent if their formulation can be accommodated within the Markov chain framework of Mehra and Prescott (1985). This note illustrates one way to create a Campbell and Cochrane-like model within the Mehra-Prescott framework. A consequence is that we can perform another sort of reverse-engineering exercize-we can calibrate the resulting model to match the stochastic discount factor derived in the Mehra-Prescott framework by Melino and Yang (2003). The Melino-Yang SDF, combined with Mehra and Prescott's consumption process, yields asset returns that exactly match the first and second moments of the data, as estimated by Mehra and Prescott.> >

Suggested Citation

  • Jim Dolmas, 2012. "Campbell and Cochrane meet Melino and Yang: reverse engineering the surplus ratio in a Mehra-Prescott economy," Working Papers 1205, Federal Reserve Bank of Dallas.
    • Handle: RePEc:fip:feddwp:1205
    DOI: 10.24149/wp1205
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    References listed on IDEAS

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    1. Angelo Melino & Alan X. Yang, 2003. "State Dependent Preferences Can Explain the Equity Premium Puzzle," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 6(4), pages 806-830, October.
    2. Campbell, John Y. & Yogo, Motohiro, 2006. "Efficient tests of stock return predictability," Journal of Financial Economics, Elsevier, vol. 81(1), pages 27-60, July.
    3. 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.
    4. Bryan R. Routledge & Stanley E. Zin, 2010. "Generalized Disappointment Aversion and Asset Prices," Journal of Finance, American Finance Association, vol. 65(4), pages 1303-1332, August.
    5. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
    6. Francisco Azeredo, 2014. "The equity premium: a deeper puzzle," Annals of Finance, Springer, vol. 10(3), pages 347-373, August.
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    More about this item

    Keywords

    Financial markets; Asset pricing;

    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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