Working Paper: CEPR ID: DP9897
Authors: Roger E. A. Farmer
Abstract: The representative agent model (RA) has dominated macroeconomics for the last thirty years. This model does a reasonably good job of explaining the co-movements of consumption, investment, GDP and employment during normal times. But it cannot easily explain movements in asset prices. Two facts are hard to understand 1) The return to equity is highly volatile and 2) The premium for holding equity, over a safe government bond, is large. The equity premium has two parts; a risk premium and a term premium. This paper constructs a lifecycle model in which agents of different generations have different savings rates and I use this model to account for a high term premium and a volatile stochastic discount factor. The fact the term premium is large, accounts for a substantial part of the observed equity premium.
Keywords: Asset Prices; Equity Premium Puzzle; Excess Volatility Puzzle
JEL Codes: G10; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| lifecycle model (O41) | observed volatility in asset prices (G17) |
| volatility in asset prices (G19) | stochastic discount factor (D15) |
| stochastic discount factor (D15) | aggregate consumption (E20) |
| aggregate consumption (E20) | behavior of different generations of agents (C92) |
| lifecycle model (O41) | equity premium (G12) |
| high term premium (G19) | differences in savings rates across generations (D15) |
| covariance between marginal utility of consumption and asset returns (D11) | equity premium (G12) |