How Can Consumption-Based Asset-Pricing Models Explain Low Interest Rates?

Abstract

The real interest rate is at historically low levels following the Great Recession. This article examines under which conditions the leading consumption-based asset-pricing models can give rise to such a reduction. In particular, we examine implications of standard constant relative risk aversion preference models with Gaussian shocks, models with consumption disaster, models with long-run risk, and models with habit formation. Given the models reviewed, the high-risk premium suggests that low interest rates in the recent period are likely to be either a consequence of a perception that consumption risk is particularly high, or of very low risk tolerance.