Working Paper: NBER ID: w24261
Authors: Roger Farmer
Abstract: This paper constructs a general equilibrium model where asset price fluctuations are caused by random shocks to beliefs about the future 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. In my model, asset price fluctuations are Pareto inefficient and there is a role for treasury or central bank intervention to stabilize asset price volatility.
Keywords: Asset Pricing; General Equilibrium; Belief Shocks
JEL Codes: E0; G1
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Belief shocks (D80) | consumption reallocations across generations (D15) |
| consumption reallocations across generations (D15) | asset price fluctuations (G19) |
| Belief shocks (D80) | asset price fluctuations (G19) |
| Belief shocks (D80) | perceived future price level (E30) |
| perceived future price level (E30) | consumption reallocations across generations (D15) |
| asset prices (G19) | belief function (D83) |