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Asset Prices in a Lifecycle Economy

  • Roger Farmer

The representative agent model (RA) has dominated macroeconomics for the last thirty years. This model does a reasonably good job of explaining the co-movements of consumption, investment, GDP and employment during normal times. But it cannot easily explain movements in asset prices. Two facts are hard to understand 1) The return to equity is highly volatile and 2) The premium for holding equity, over a safe government bond, is large. The equity premium has two parts; a risk premium and a term premium. This paper constructs a lifecycle model in which agents of different generations have different savings rates and I use this model to account for a high term premium and a volatile stochastic discount factor. The fact the term premium is large, accounts for a substantial part of the observed equity premium.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 19958.

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Date of creation: Mar 2014
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Handle: RePEc:nbr:nberwo:19958
Note: EFG IFM
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  1. Karl Schmedders & Felix Kubler, 2012. "Life-Cycle Portfolio Choice, the Wealth Distribution and Asset Prices," 2012 Meeting Papers 536, Society for Economic Dynamics.
  2. Constantinides, George M, 1990. "Habit Formation: A Resolution of the Equity Premium Puzzle," Journal of Political Economy, University of Chicago Press, vol. 98(3), pages 519-43, June.
  3. Shiller, Robert J, 1981. "Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends?," American Economic Review, American Economic Association, vol. 71(3), pages 421-36, June.
  4. Jessica A. Wachter, 2013. "Can Time-Varying Risk of Rare Disasters Explain Aggregate Stock Market Volatility?," Journal of Finance, American Finance Association, vol. 68(3), pages 987-1035, 06.
  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. Cochrane, John H. & Campbell, John, 1999. "By Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior," Scholarly Articles 3119444, Harvard University Department of Economics.
  7. Ghosh, Anisha & Julliard, Christian, 2012. "Can Rare Events Explain the Equity Premium Puzzle?," CEPR Discussion Papers 8899, C.E.P.R. Discussion Papers.
  8. Roger E.A. Farmer & Carine Nourry & Alain Venditti, 2012. "The Inefficient Markets Hypothesis: Why Financial Markets Do Not Work Well in the Real World," NBER Working Papers 18647, National Bureau of Economic Research, Inc.
  9. Constantinides,George & Duffie,Darrel, 1992. "Asset pricing with heterogeneous consumers," Discussion Paper Serie A 381, University of Bonn, Germany.
  10. Michael Woodford, 2001. "Fiscal Requirements for Price Stability," NBER Working Papers 8072, National Bureau of Economic Research, Inc.
  11. Balasko, Yves & Cass, David, 1989. "The Structure of Financial Equilibrium with Exogenous Yields: The Case of Incomplete Markets," Econometrica, Econometric Society, vol. 57(1), pages 135-62, January.
  12. Cass, David & Shell, Karl, 1983. "Do Sunspots Matter?," Journal of Political Economy, University of Chicago Press, vol. 91(2), pages 193-227, April.
  13. Ravi Bansal & Amir Yaron, 2000. "Risks for the Long Run: A Potential Resolution of Asset Pricing Puzzles," NBER Working Papers 8059, National Bureau of Economic Research, Inc.
  14. Blanchard, Olivier J, 1985. "Debt, Deficits, and Finite Horizons," Journal of Political Economy, University of Chicago Press, vol. 93(2), pages 223-47, April.
  15. Epstein, Larry G & Zin, Stanley E, 1989. "Substitution, Risk Aversion, and the Temporal Behavior of Consumption and Asset Returns: A Theoretical Framework," Econometrica, Econometric Society, vol. 57(4), pages 937-69, July.
  16. Rietz, Thomas A., 1988. "The equity risk premium a solution," Journal of Monetary Economics, Elsevier, vol. 22(1), pages 117-131, July.
  17. Azariadis, Costas, 1981. "Self-fulfilling prophecies," Journal of Economic Theory, Elsevier, vol. 25(3), pages 380-396, December.
  18. 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.
  19. Xavier Gabaix, 2007. "Linearity-Generating Processes: A Modelling Tool Yielding Closed Forms for Asset Prices," NBER Working Papers 13430, National Bureau of Economic Research, Inc.
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