Is Consumption Growth merely a Sideshow in Asset Pricing?

Abstract

I study a parsimonious model of a time-varying market risk premium. State pricing is dominated by time preference shocks that may be independent of the consumption process. The model resolves several asset pricing puzzles and provides predictions for how the risk premium varies with measurable financial quantities like the price-earnings ratio and interest rates. Time preference shocks can generate a low level and volatility in the real interest rate and a high stock price volatility and equity premium. The price-earnings ratio has power to predict future stock returns and reveals information about unobservable financial quantities.

Keywords: time preference shocks, taste shocks, demand shocks, equity premium, risk-free rate puzzle, correlation puzzle, consumption based asset pricing, general equilibrium, recursive preferences, return predictability, auto-correlation in stock return

JEL Classification: G11, G12, G14, G17, D51