Ambiguity Aversion, the Equity Premium and the Welfare Costs of Business Cycles
We examine the potential importance of consumer ambiguity aversion for asset prices and how consumption ‡fluctuations influence consumer welfare. First, considering a simple Mehra-Prescott-style endowment economy with a representative agent facing consumption fluctuations calibrated to match U.S. data, we study to what extent ambiguity aversion can deliver asset prices that are consistent with data: a high return on equity and a low return on riskfree bonds. For some configurations of preference parameters— a discount factor, a degree of relative risk aversion, and a measure of ambiguity aversion— we find that it can. Then, we use these parameter configurations to investigate how much consumers would be willing to pay to reduce endowment fluctuations to zero, thus delivering a Lucas-style welfare cost of fluctuations. These costs turn out to be very large: consumers are willing to pay over 10% of consumption in permanent terms.
|Date of creation:||06 Aug 2007|
|Date of revision:|
|Contact details of provider:|| Postal: Institute for International Economic Studies, Stockholm University, S-106 91 Stockholm, Sweden|
Web page: http://www.iies.su.se/
More information through EDIRC
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.:
- Larry Epstein & Martin Schneider, 2005.
"Ambiguity, Information Quality and Asset Pricing,"
RCER Working Papers
519, University of Rochester - Center for Economic Research (RCER).
- repec:cup:macdyn:v:8:y:2004:i:5:p:617-32 is not listed on IDEAS
- David Schmeidler, 1989.
"Subjective Probability and Expected Utility without Additivity,"
Levine's Working Paper Archive
7662, David K. Levine.
- Schmeidler, David, 1989. "Subjective Probability and Expected Utility without Additivity," Econometrica, Econometric Society, vol. 57(3), pages 571-87, May.
- Coen-Pirani, Daniele, 2004. "Effects Of Differences In Risk Aversion On The Distribution Of Wealth," Macroeconomic Dynamics, Cambridge University Press, vol. 8(05), pages 617-632, November.
- Robert E. Lucas Jr. & Nancy L. Stokey, 1982.
"Optimal Growth with Many Consumers,"
518, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
- Mehra, Rajnish & Prescott, Edward C., 1985.
"The equity premium: A puzzle,"
Journal of Monetary Economics,
Elsevier, vol. 15(2), pages 145-161, March.
- Robert E. Lucas Jr., 2003. "Macroeconomic Priorities," American Economic Review, American Economic Association, vol. 93(1), pages 1-14, March.
- Larry G. Epstein & Martin Schneider, 2001.
RCER Working Papers
485, University of Rochester - Center for Economic Research (RCER).
- Epstein, Larry G & Wang, Tan, 1994. "Intertemporal Asset Pricing Under Knightian Uncertainty," Econometrica, Econometric Society, vol. 62(2), pages 283-322, March.
When requesting a correction, please mention this item's handle: RePEc:hhs:iiessp:0752. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Hanna Christiansson)
If references are entirely missing, you can add them using this form.