Long-Run Risk through Consumption Smoothing

We show that a standard production economy model where consumers have Epstein-Zin preferences can jointly explain the low volatility of consumption growth and a high market price of risk with a low coefficient of relative risk aversion (5). Endogenous consumption smoothing increases the price of risk in this economy as it induces highly persistent time-variation in expected aggregate consumption growth (long-run risk), even though technology follows a random walk. As is usual in production economy models, the volatility of equity returns is quite low. We propose an extension where we calibrate the wage process to the data and show that this brings the equity volatility, and thus the equity premium, much closer to historical values. The model identifies an observable proxy for otherwise hard to measure expected consumption growth. Using this proxy, we test and find support for key predictions of our model in the time-series of consumption growth and the cross-section of stock returns.