Working Paper: CEPR ID: DP3697
Authors: Jean-Pierre Danthine; John B. Donaldson; Chrisos Giannikos; Hany Guirguis
Abstract: This Paper introduces state dependent utility into the standard Mehra and Prescott (1985) economy by allowing the representative agent?s coefficient of relative risk aversion to vary with the underlying economy?s growth rate. Existence of equilibrium is proved and its asymptotic properties analysed. This generalization leads to level dependent marginal rates of substitution, a property that sharply distinguishes this model from the standard construct. For very low coefficients of relative risk aversion, the equilibrium risk free and risky security returns are demonstrated to have volatilities and an associated equity premium that substantially exceed what is found in the data. This provides a contrasting perspective on the classic ?equity premium puzzle.?
Keywords: equity premium; equity premium puzzle; state-dependent utility
JEL Codes: D91; E21; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| state-dependent preferences (D11) | asset pricing outcomes (G19) |
| growth rate of consumption (E20) | representative agent's demand for securities (G19) |
| level of consumption (D12) | representative agent's demand for securities (G19) |
| coefficient of relative risk aversion varies with growth rate of consumption (D11) | level-dependent marginal rate of substitution (D11) |
| level-dependent marginal rate of substitution (D11) | additional volatility in asset pricing (G19) |
| growth rate of consumption increases (E20) | standard deviation of intertemporal marginal rate of substitution increases (D15) |
| standard deviation of intertemporal marginal rate of substitution increases (D15) | higher equilibrium risk-free asset prices (G19) |
| standard deviation of intertemporal marginal rate of substitution increases (D15) | lower risk-free rates (G19) |
| equity premium (G12) | standard deviations of all security returns (C46) |
| standard deviations of all security returns (C46) | satisfy Hansen-Jagannathan bounds (C51) |