Working Paper: NBER ID: w22485
Authors: John H. Cochrane
Abstract: Macro-finance addresses the link between asset prices and economic fluctuations. Many models reflect the same rough idea: the market's ability to bear risk varies over time, larger in good times, and less in bad times. Models achieve this similar result by quite different mechanisms, and I contrast their strengths and weaknesses. I outline how macro-finance models may illuminate macroeconomics, by putting time-varying risk aversion, risk-bearing capacity, and precautionary savings at the center of recessions rather than variation in “the” interest rate and intertemporal substitution. I emphasize unsolved questions and profitable avenues for research.
Keywords: macrofinance; asset prices; economic fluctuations; risk aversion; equity premium
JEL Codes: E00; G10; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Consumption falls during recessions (E21) | Increased risk aversion (D81) |
| Increased risk aversion (D81) | Higher expected returns on stocks (G17) |
| Consumption falls during recessions (E21) | Higher expected returns on stocks (G17) |
| Economic downturns (E32) | Higher equity premium (G19) |
| State of the economy influences predictability of returns (G17) | Expected returns being higher during recessions (G17) |
| Higher expected returns during recessions (G19) | Risk premiums are high (G19) |