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Risk Aversion, the Labor Margin, and Asset Pricing in DSGE Models

  • Eric Swanson

    (Federal Reserve Bank of San Francisco)

In dynamic equilibrium models, the household's labor margin has dramatic effects on risk aversion, and hence asset prices, even when utility is additively separable between consumption and labor. This paper derives simple, closed-form expressions for risk aversion that take into account the household's labor margin. Ignoring the labor margin can wildly overstate the household's true aversion to risk. Risk premia on assets priced with the stochastic discount factor increase essentially linearly with risk aversion, so measuring risk aversion correctly is crucial for asset pricing in the model. Closed-form expressions for risk aversion in DSGE models with generalized recursive preferences and internal and external habits are also derived.

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Paper provided by Society for Economic Dynamics in its series 2010 Meeting Papers with number 138.

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Date of creation: 2010
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Handle: RePEc:red:sed010:138
Contact details of provider: Postal: Society for Economic Dynamics Christian Zimmermann Economic Research Federal Reserve Bank of St. Louis PO Box 442 St. Louis MO 63166-0442 USA
Fax: 1-314-444-8731
Web page: http://www.EconomicDynamics.org/society.htm
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  1. G. Constantinides, 1990. "Habit formation: a resolution of the equity premium puzzle," Levine's Working Paper Archive 1397, David K. Levine.
  2. Lawrence J. Christiano & Michele Boldrin & Jonas D. M. Fisher, 2001. "Habit Persistence, Asset Returns, and the Business Cycle," American Economic Review, American Economic Association, vol. 91(1), pages 149-166, March.
  3. Phillippe Weil, 1997. "The Equity Premium Puzzle and the Risk-Free Rate Puzzle," Levine's Working Paper Archive 1833, David K. Levine.
  4. Michele Boldrin & Lawrence J. Christiano & Jonas D.M. Fisher, 1997. "Habit persistence and asset returns in an exchange economy," Working Paper Series, Macroeconomic Issues WP-97-04, Federal Reserve Bank of Chicago.
  5. Kihlstrom, Richard E. & Mirman, Leonard J., 1974. "Risk aversion with many commodities," Journal of Economic Theory, Elsevier, vol. 8(3), pages 361-388, July.
  6. Glenn D. Rudebusch & Eric T. Swanson, 2008. "Examining the bond premium puzzle with a DSGE model," Working Paper Series 2007-25, Federal Reserve Bank of San Francisco.
  7. 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.
  8. John Y. Campbell & John H. Cochrane, 1995. "By Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior," NBER Working Papers 4995, National Bureau of Economic Research, Inc.
  9. Benveniste, L M & Scheinkman, J A, 1979. "On the Differentiability of the Value Function in Dynamic Models of Economics," Econometrica, Econometric Society, vol. 47(3), pages 727-32, May.
  10. TallariniJr., Thomas D., 2000. "Risk-sensitive real business cycles," Journal of Monetary Economics, Elsevier, vol. 45(3), pages 507-532, June.
  11. Stiglitz, Joseph E, 1969. "Behavior Towards Risk with Many Commodities," Econometrica, Econometric Society, vol. 37(4), pages 660-67, October.
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