IDEAS home Printed from https://ideas.repec.org/p/man/cgbcrp/225.html
   My bibliography  Save this paper

When the Going Gets Tough: Durable Consumption and the Equity Premium

Author

Listed:
  • Myroslav Pidkuyko

Abstract

I present an endowment economy where a representative agent has recursive preferences over the consumption of non-durable and durable goods, and uncertainty about the underlying endowments. Using parameter calibration consistent with real business cycle literature (risk aversion coefficient of 2.1 and elasticity of intertemporal substitution of 1.09), the model generates a high level of equity premium and a low and stable risk-free rate. The model is also able to explain up to 60% of the equity volatility. The volatile expenditure on durable consumption goods generates a high and volatile equity premium; endogenous time-varying uncertainty produces a counter-cyclical equity premium.

Suggested Citation

  • Myroslav Pidkuyko, 2016. "When the Going Gets Tough: Durable Consumption and the Equity Premium," Centre for Growth and Business Cycle Research Discussion Paper Series 225, Economics, The University of Manchester.
    • Handle: RePEc:man:cgbcrp:225
    as

    Download full text from publisher

    File URL: http://hummedia.manchester.ac.uk/schools/soss/cgbcr/discussionpapers/dpcgbcr225.pdf
    Download Restriction: no
    ---><---

    References listed on IDEAS

    as
    1. Cecchetti, Stephen G. & Lam, Pok-sang & Mark, Nelson C., 1993. "The equity premium and the risk-free rate : Matching the moments," Journal of Monetary Economics, Elsevier, vol. 31(1), pages 21-45, February.
    2. Brandt, M.W.Michael W. & Zeng, Qi & Zhang, Lu, 2004. "Equilibrium stock return dynamics under alternative rules of learning about hidden states," Journal of Economic Dynamics and Control, Elsevier, vol. 28(10), pages 1925-1954, September.
    3. Eichenbaum, Martin & Hansen, Lars Peter, 1990. "Estimating Models with Intertemporal Substitution Using Aggregate Time Series Data," Journal of Business & Economic Statistics, American Statistical Association, vol. 8(1), pages 53-69, January.
    4. Yang, Wei, 2011. "Long-run risk in durable consumption," Journal of Financial Economics, Elsevier, vol. 102(1), pages 45-61, October.
    5. Larry G. Epstein & Martin Schneider, 2008. "Ambiguity, Information Quality, and Asset Pricing," Journal of Finance, American Finance Association, vol. 63(1), pages 197-228, February.
    6. João F. Gomes & Leonid Kogan & Motohiro Yogo, 2009. "Durability of Output and Expected Stock Returns," Journal of Political Economy, University of Chicago Press, vol. 117(5), pages 941-986.
    7. Masao Ogaki & Carmen M. Reinhart, 1998. "Measuring Intertemporal Substitution: The Role of Durable Goods," Journal of Political Economy, University of Chicago Press, vol. 106(5), pages 1078-1098, October.
    8. Epstein, Larry G & Zin, Stanley E, 1991. "Substitution, Risk Aversion, and the Temporal Behavior of Consumption and Asset Returns: An Empirical Analysis," Journal of Political Economy, University of Chicago Press, vol. 99(2), pages 263-286, April.
    9. Dunn, Kenneth B. & Singleton, Kenneth J., 1986. "Modeling the term structure of interest rates under non-separable utility and durability of goods," Journal of Financial Economics, Elsevier, vol. 17(1), pages 27-55, September.
    10. Larry G. Epstein & Stanley E. Zin, 2013. "Substitution, risk aversion and the temporal behavior of consumption and asset returns: A theoretical framework," World Scientific Book Chapters, in: Leonard C MacLean & William T Ziemba (ed.), HANDBOOK OF THE FUNDAMENTALS OF FINANCIAL DECISION MAKING Part I, chapter 12, pages 207-239, World Scientific Publishing Co. Pte. Ltd..
    11. Michael Johannes & Lars A. Lochstoer & Yiqun Mou, 2016. "Learning about Consumption Dynamics," Journal of Finance, American Finance Association, vol. 71(2), pages 551-600, April.
    12. Qiang Dai & Kenneth J. Singleton & Wei Yang, 2007. "Regime Shifts in a Dynamic Term Structure Model of U.S. Treasury Bond Yields," The Review of Financial Studies, Society for Financial Studies, vol. 20(5), pages 1669-1706, 2007 12.
    13. Mark Schneider & Jonathan W. Leland & Nathaniel T. Wilcox, 2018. "Ambiguity framed," Journal of Risk and Uncertainty, Springer, vol. 57(2), pages 133-151, October.
      • Mark Schneider & Jonathan Leland & Nathaniel T. Wilcox, 2016. "Ambiguity Framed," Working Papers 16-11, Chapman University, Economic Science Institute.
    14. Ravi Bansal & Amir Yaron, 2004. "Risks for the Long Run: A Potential Resolution of Asset Pricing Puzzles," Journal of Finance, American Finance Association, vol. 59(4), pages 1481-1509, August.
    15. Tomáš Havránek, 2015. "Measuring Intertemporal Substitution: The Importance Of Method Choices And Selective Reporting," Journal of the European Economic Association, European Economic Association, vol. 13(6), pages 1180-1204, December.
    16. John Y. Campbell, Robert J. Shiller, 1988. "The Dividend-Price Ratio and Expectations of Future Dividends and Discount Factors," The Review of Financial Studies, Society for Financial Studies, vol. 1(3), pages 195-228.
    17. Yihong Xia, 2001. "Learning about Predictability: The Effects of Parameter Uncertainty on Dynamic Asset Allocation," Journal of Finance, American Finance Association, vol. 56(1), pages 205-246, February.
    18. Motohiro Yogo, 2006. "A Consumption‐Based Explanation of Expected Stock Returns," Journal of Finance, American Finance Association, vol. 61(2), pages 539-580, April.
    19. Ang, Andrew & Bekaert, Geert, 2002. "Regime Switches in Interest Rates," Journal of Business & Economic Statistics, American Statistical Association, vol. 20(2), pages 163-182, April.
    20. Judd, Kenneth L., 1992. "Projection methods for solving aggregate growth models," Journal of Economic Theory, Elsevier, vol. 58(2), pages 410-452, December.
    21. Hamilton, James D, 1989. "A New Approach to the Economic Analysis of Nonstationary Time Series and the Business Cycle," Econometrica, Econometric Society, vol. 57(2), pages 357-384, March.
    22. Fama, Eugene F. & French, Kenneth R., 1988. "Dividend yields and expected stock returns," Journal of Financial Economics, Elsevier, vol. 22(1), pages 3-25, October.
    23. Veronesi, Pietro, 1999. "Stock Market Overreaction to Bad News in Good Times: A Rational Expectations Equilibrium Model," The Review of Financial Studies, Society for Financial Studies, vol. 12(5), pages 975-1007.
    Full references (including those not matched with items on IDEAS)

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Julian Thimme, 2017. "Intertemporal Substitution In Consumption: A Literature Review," Journal of Economic Surveys, Wiley Blackwell, vol. 31(1), pages 226-257, February.
    2. Pakoš, Michal, 2013. "Long-run risk and hidden growth persistence," Journal of Economic Dynamics and Control, Elsevier, vol. 37(9), pages 1911-1928.
    3. Fabrice Collard & Sujoy Mukerji & Kevin Sheppard & Jean‐Marc Tallon, 2018. "Ambiguity and the historical equity premium," Quantitative Economics, Econometric Society, vol. 9(2), pages 945-993, July.
    4. Bjørn Eraker & Ivan Shaliastovich & Wenyu Wang, 2016. "Durable Goods, Inflation Risk, and Equilibrium Asset Prices," The Review of Financial Studies, Society for Financial Studies, vol. 29(1), pages 193-231.
    5. Nengjiu Ju & Jianjun Miao, 2012. "Ambiguity, Learning, and Asset Returns," Econometrica, Econometric Society, vol. 80(2), pages 559-591, March.
    6. Yang, Wei, 2011. "Long-run risk in durable consumption," Journal of Financial Economics, Elsevier, vol. 102(1), pages 45-61, October.
    7. Yiqun Mou & Lars A. Lochstoer & Michael Johannes, 2011. "Learning about Consumption Dynamics," 2011 Meeting Papers 306, Society for Economic Dynamics.
    8. Chen, Guojin & Hong, Zhiwu & Ren, Yu, 2016. "Durable consumption and asset returns: Cointegration analysis," Economic Modelling, Elsevier, vol. 53(C), pages 231-244.
    9. Campbell, John Y., 2003. "Consumption-based asset pricing," Handbook of the Economics of Finance, in: G.M. Constantinides & M. Harris & R. M. Stulz (ed.), Handbook of the Economics of Finance, edition 1, volume 1, chapter 13, pages 803-887, Elsevier.
    10. Ruan, Xinfeng & Zhang, Jin E., 2018. "Equilibrium variance risk premium in a cost-free production economy," Journal of Economic Dynamics and Control, Elsevier, vol. 96(C), pages 42-60.
    11. Brandt, M.W.Michael W. & Zeng, Qi & Zhang, Lu, 2004. "Equilibrium stock return dynamics under alternative rules of learning about hidden states," Journal of Economic Dynamics and Control, Elsevier, vol. 28(10), pages 1925-1954, September.
    12. Committee, Nobel Prize, 2013. "Understanding Asset Prices," Nobel Prize in Economics documents 2013-1, Nobel Prize Committee.
    13. Bidarkota, Prasad V. & Dupoyet, Brice V. & McCulloch, J. Huston, 2009. "Asset pricing with incomplete information and fat tails," Journal of Economic Dynamics and Control, Elsevier, vol. 33(6), pages 1314-1331, June.
    14. Hui Chen & Nengjiu Ju & Jianjun Miao, 2014. "Dynamic Asset Allocation with Ambiguous Return Predictability," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 17(4), pages 799-823, October.
    15. João F. Gomes & Leonid Kogan & Motohiro Yogo, 2009. "Durability of Output and Expected Stock Returns," Journal of Political Economy, University of Chicago Press, vol. 117(5), pages 941-986.
    16. Elminejad, Ali & Havranek, Tomas & Irsova, Zuzana, 2022. "Relative Risk Aversion: A Meta-Analysis," MetaArXiv b8uhe, Center for Open Science.
    17. Guidolin, Massimo & Timmermann, Allan, 2007. "Asset allocation under multivariate regime switching," Journal of Economic Dynamics and Control, Elsevier, vol. 31(11), pages 3503-3544, November.
    18. Roh, Tai-Yong & Lee, Changjun & Min, Byoung-Kyu, 2019. "Consumption growth predictability and asset prices," Journal of Empirical Finance, Elsevier, vol. 51(C), pages 95-118.
    19. Mykola Babiak, 2017. "Generalized Disappointment Aversion, Learning, and Asset Prices," CERGE-EI Working Papers wp606, The Center for Economic Research and Graduate Education - Economics Institute, Prague.
    20. Grammig, Joachim & Küchlin, Eva-Maria, 2017. "A two-step indirect inference approach to estimate the long-run risk asset pricing model," CFS Working Paper Series 572, Center for Financial Studies (CFS).

    More about this item

    NEP fields

    This paper has been announced in the following NEP Reports:

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:man:cgbcrp:225. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Marianne Sensier (email available below). General contact details of provider: https://edirc.repec.org/data/semanuk.html .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.