Working Paper: CEPR ID: DP5110
Authors: Carlo A. Favero
Abstract: Consumption is striking back. Some recent evidence indicates that the well-known asset pricing puzzles generated by the difficulties of matching fluctuations in asset prices with high frequency fluctuations in consumption might be solved by considering consumption in the long-run. A first strand of the literature concentrates on multiperiod differences in log consumption, a second concentrates on the cointegrating relation for consumption. Interestingly, only the (multiperiod) Euler Equation for the consumer optimization problem is considered by the first strand of the literature, while the cointegration-based literature concentrates exclusively on the (linearized) intertemporal budget constraint. In this paper, we show that using the first order condition in the linearized budget constraint to derive an explicit long-run consumption function delivers an even more striking strike back.
Keywords: cointegrating consumption function; elasticity of intertemporal substitution; long-run stock market returns
JEL Codes: E20; E44; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| deviations of consumption from its long-run equilibrium (D59) | long-run stock market returns (G17) |
| consumption-wealth ratio (E21) | future market returns (G17) |
| elasticity of intertemporal substitution influences relationship (D15) | excess consumption and expected returns (E21) |
| deviations in consumption from its long-run trend (E20) | predict future stock market returns (G17) |