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Asset Pricing, Growth, And The Business Cycle With Irreversible Investment

  • Miquel Faig

This paper advances a simple model that emphasizes the diversity of capital types, some of these types are long lived, while others are highly specific. This modeling of capital implies that irreversibility constraints may be strongly binding, thus generating sizable capital losses, even with moderate shocks and positive aggregate investment. The resulting riskiness of investing in capital has consequences for growth, the business cycle, and asset returns. Growth is affected as the representative consumer invests a larger portion of output as a form of self-insurance. The business cycle is affected as consumption becomes more variable. The asset returns are affected as the added risk raises its premium, specially in recessions. The focus of the paper is to evaluate the quantitative importance of these effects. When evaluated, the model is capable of matching the most prominent characteristics of U.S. output, consumption, and asset returns, including a wide equity premium. However, this is not a resolution to the equity premium puzzle as the paper does not address why the representative consumer has the high risk aversion necessary to match these observed time series.

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File URL: https://www.economics.utoronto.ca/public/workingPapers/UT-ECIPA-FAIG-98-02.pdf
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Paper provided by University of Toronto, Department of Economics in its series Working Papers with number faig-98-02.

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Length: 26 pages
Date of creation: 11 Sep 1999
Date of revision:
Handle: RePEc:tor:tecipa:faig-98-02
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  1. Beaudry, Paul & Guay, Alain, 1996. "What do interest rates reveal about the functioning of real business cycle models?," Journal of Economic Dynamics and Control, Elsevier, vol. 20(9-10), pages 1661-1682.
  2. Michele Boldrin & Lawrence J. Christiano & Jonas D.M. Fisher, 1995. "Asset pricing lessons for modeling business cycles," Working Paper Series, Macroeconomic Issues 95-11, Federal Reserve Bank of Chicago.
  3. Marcelo Veracierto, 1998. "Plant level irreversible investment and equilibrium business cycles," Working Paper Series WP-98-1, Federal Reserve Bank of Chicago.
  4. Sargent, Thomas J., 1980. ""Tobin's q" and the rate of investment in general equilibrium," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 12(1), pages 107-154, January.
  5. Jermann, Urban J., 1998. "Asset pricing in production economies," Journal of Monetary Economics, Elsevier, vol. 41(2), pages 257-275, April.
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  7. Miquel Faig, 1998. "Understanding Investment Irreversibility In General Equilibrium," Working Papers faig-98-01, University of Toronto, Department of Economics.
  8. 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.
  9. Dow, J.P.J. & Olson, L.J., 1990. ""Irreversibility and the Behavior of Aggregate Stochastic Growth Models"," The A. Gary Anderson Graduate School of Management 90-10, The A. Gary Anderson Graduate School of Management. University of California Riverside.
  10. Christiano, Lawrence J. & Fisher, Jonas D. M., 2000. "Algorithms for solving dynamic models with occasionally binding constraints," Journal of Economic Dynamics and Control, Elsevier, vol. 24(8), pages 1179-1232, July.
  11. Valerie A. Ramey & Matthew D. Shapiro, 1998. "Displaced Capital," NBER Working Papers 6775, National Bureau of Economic Research, Inc.
  12. 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.
  13. Weil, Philippe, 1989. "The equity premium puzzle and the risk-free rate puzzle," Journal of Monetary Economics, Elsevier, vol. 24(3), pages 401-421, November.
  14. Lawrence J. Christiano & Jonas Fisher, 1995. "Tobin's q and Asset Returns: Implications for Business Cycle Analysis," NBER Working Papers 5292, National Bureau of Economic Research, Inc.
  15. Kocherlakota, N., 1995. "The Equity Premium: It's Still a Puzzle," Working Papers 95-05, University of Iowa, Department of Economics.
  16. Coleman Ii, Wilbur John, 1997. "Behavior Of Interest Rates In A General Equilibrium Multisector Model With Irreversible Investment," Macroeconomic Dynamics, Cambridge University Press, vol. 1(01), pages 206-227, January.
  17. Michael J. Boskin, 1998. "Consumer Prices, the Consumer Price Index, and the Cost of Living," Journal of Economic Perspectives, American Economic Association, vol. 12(1), pages 3-26, Winter.
  18. Barro, Robert J, 1990. "Government Spending in a Simple Model of Endogenous Growth," Journal of Political Economy, University of Chicago Press, vol. 98(5), pages S103-26, October.
  19. Constantinides, George M & Duffie, Darrell, 1996. "Asset Pricing with Heterogeneous Consumers," Journal of Political Economy, University of Chicago Press, vol. 104(2), pages 219-40, April.
  20. R. Mehra & E. Prescott, 2010. "The equity premium: a puzzle," Levine's Working Paper Archive 1401, David K. Levine.
  21. Ferson, Wayne E & Harvey, Campbell R, 1991. "The Variation of Economic Risk Premiums," Journal of Political Economy, University of Chicago Press, vol. 99(2), pages 385-415, April.
  22. Valerie A. Ramey & Matthew D. Shapiro, 1999. "Costly Capital Reallocation and the Effects of Government Spending," NBER Working Papers 6283, National Bureau of Economic Research, Inc.
  23. 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.
  24. Kjetil Storesletten & Chris Telmer & Amir Yaron, . "Persistent Idiosyncratic Shocks and Incomplete Markets," GSIA Working Papers 24, Carnegie Mellon University, Tepper School of Business.
  25. Thomas Tallarini, . "Risk-Sensitive Real Business Cycles," GSIA Working Papers 1997-35, Carnegie Mellon University, Tepper School of Business.
  26. Cochrane, John H, 1996. "A Cross-Sectional Test of an Investment-Based Asset Pricing Model," Journal of Political Economy, University of Chicago Press, vol. 104(3), pages 572-621, June.
  27. Fama, Eugene F & French, Kenneth R, 1988. "Permanent and Temporary Components of Stock Prices," Journal of Political Economy, University of Chicago Press, vol. 96(2), pages 246-73, April.
  28. Olson, Lars J., 1989. "Stochastic growth with irreversible investment," Journal of Economic Theory, Elsevier, vol. 47(1), pages 101-129, February.
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