Consumption-Based Asset Pricing When Consumers Make Mistakes

Abstract

I analyze the implications of allowing consumers to make mistakes on the risk-return relationships predicted by consumption-based asset pricing models. I allow for consumption mistakes using a model in which a portfolio manager selects investments on a consumer's behalf. The consumer has an arbitrary consumption policy that could reflect a wide range of mistakes. For power utility, expected returns do not generally depend on exposure to single-period consumption shocks, but robustly depend on exposure to both long-run consumption and expected return shocks. I empirically show that separately accounting for both types of shocks helps explain the equity premium and cross section of stock returns.

A Monetary Policy Asset Pricing Model

“…In recent work,Anderson (2021) shows that allowing for consumption mistakes can improve the empirical success of the consumption CAPM, but he does not analyze nominal rigidities or monetary policy (see alsoLynch (1996);Marshall and Parekh (1999);Gabaix and Laibson (2001)). …”