Working Paper: NBER ID: w22228
Authors: Roger E. A. Farmer
Abstract: This paper constructs a general equilibrium model with two types of people where asset price fluctuations are caused by random shocks to the price level that reallocate consumption across generations. In this model, asset prices are volatile, and price-earnings ratios are persistent, even though there is no fundamental uncertainty and financial markets are sequentially complete. I show that the model can explain a substantial risk premium while generating smooth time series for consumption and financial assets across types. In my model, asset price fluctuations are Pareto inefficient and there is a role for treasury or central bank intervention to stabilize asset prices.
Keywords: Asset Pricing; Belief Shocks; General Equilibrium Model
JEL Codes: E0; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| belief shocks (D83) | asset price volatility (G19) |
| belief shocks (D83) | resource reallocation between generations (D15) |
| government intervention (O25) | stabilization of asset prices (G19) |