A Parsimonious Macroeconomic Model for Asset Pricing

Fatih Guvenen

No 15243, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: In this paper, I study asset prices in a two-agent macroeconomic model with two key features: limited participation in the stock market and heterogeneity in the elasticity of intertemporal substitution in consumption (EIS). The model is consistent with some prominent features of asset prices that have been documented in the literature, such as a high equity premium; relatively smooth interest rates; procyclical variation in stock prices; and countercyclical variation in the equity premium, in its volatility, and in the Sharpe ratio. While the model also reproduces the long-horizon predictability of the equity premium, the extent of predictability is smaller than in the data. In this model, the risk-free asset market plays a central role by allowing the non-stockholders (who have low EIS) to smooth the fluctuations in their labor income. This process concentrates nonstockholders' aggregate labor income risk among a small group of stockholders, who then demand a high premium for bearing the aggregate equity risk. Furthermore, this mechanism is consistent with the very small share of aggregate wealth held by non-stockholders in the US data, which has proved problematic for previous models with limited participation. I show that this large wealth inequality is also important for the model's ability to generate a countercyclical equity premium. Finally, when it comes to business cycle performance the model's progress has been more limited: consumption is still too volatile compared to the US data, whereas investment is still too smooth. These are important areas for potential improvement in this framework.

JEL-codes: E21 E32 E44 G12 (search for similar items in EconPapers)
Date: 2009-08
New Economics Papers: this item is included in nep-bec, nep-dge and nep-mac
Note: AP EFG ME
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (223)

Published as Fatih Guvenen, 2009. "A Parsimonious Macroeconomic Model for Asset Pricing," Econometrica, Econometric Society, vol. 77(6), pages 1711-1750, November.

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Journal Article: A Parsimonious Macroeconomic Model for Asset Pricing (2009)
Working Paper: A parsimonious macroeconomic model for asset pricing (2009)
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