Asset Pricing in Production Economies with Extrapolative Expectations

Abstract

Introducing extrapolation bias into a standard one-sector production-based real business cycle model with recursive preferences reconciles salient stylized facts about business cycles (low consumption volatility and high investment volatility relative to output) and financial markets (high equity premium, volatile stock returns, and a low and smooth riskfree rate) with low relative risk aversion and an intertemporal elasticity of substitution in preferences of greater than one. Furthermore, the model matches several conditional stylized facts, such as return predictability based upon dividend yield, Q, and investment rates. These successes derive from the interaction of capital adjustment costs, extrapolative bias, and recursive preferences. Extrapolative bias increases the variation in the wealth-consumption ratio; recursive preferences cause this variation to be strongly priced; and adjustment costs decrease the covariance between marginal utility of consumption and asset returns. We provide empirical support for the mechanism of the model. JEL Classification: G02, G12, G14, E30

Diagnostic Expectations and Credit Cycles

“…Many models of beliefs in finance are motivated by psychological evidence, but often use specifications specialized to financial markets (e.g., Muth (), Barberis, Shleifer, and Vishny (), Rabin and Vayanos (), Fuster, Laibson, and Mendel (), Hirshleifer, Li, and Yu (), Greenwood and Hanson (), Barberis et al. ()).…”

Diagnostic Expectations and Credit Cycles

“…An older literature on financial asset prices and economic activity includesBernanke (1990), Friedman andKuttner (1992), andStock and Watson (2003), among others. 3 Many models of beliefs in finance are motivated by psychological evidence, but often use specifications specialized to financial markets (e.g.,Muth 1961, Barberis, Shleifer, and Vishny 1998, Rabin and Vayanos 2010, Fuster, Laibson, and Mendel 2010, Hirshleifer et al 2015, Greenwood and Hanson 2015, Barberis et al 2015a Fuster et al (2010). review evidence from lab and field settings documenting deviations from rational expectations.…”

Stock Price Cycles and Business Cycles

“…Tallarini 2000, Gourio (2012), Croce (2014) and Hirshleifer, Li, and Yu (2015) discuss the asset pricing predictions of the real business cycle models under Epstein-Zin preferences (Epstein and Zin, 1989), assuming that the coe¢ cient of risk aversion is larger than the inverse of the EIS. Tallarini (2000) shows that increasing risk aversionwhile keeping the EIS …xed and equal to one -barely a¤ects business cycle dynamics, but has substantial e¤ects on the price of risk.…”