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107
Consumption Strikes Back? Measuring LongRun Risk
, 2008
"... We characterize and measure a longterm riskreturn tradeoff for the valuation of cash flows exposed to fluctuations in macroeconomic growth. This tradeoff features risk prices of cash flows that are realized far into the future but continue to be reflected in asset values. We apply this analysis ..."
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Cited by 230 (31 self)
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We characterize and measure a longterm riskreturn tradeoff for the valuation of cash flows exposed to fluctuations in macroeconomic growth. This tradeoff features risk prices of cash flows that are realized far into the future but continue to be reflected in asset values. We apply this analysis to claims on aggregate cash flows and to cash flows from value and growth portfolios by imputing values to the longrun dynamic responses of cash flows to macroeconomic shocks. We explore the sensitivity of our results to features of the economic valuation model and of the model cash flow dynamics.
The Bond Premium in a DSGE Model with LongRun Real and Nominal Risks
, 2009
"... The term premium on nominal longterm bonds in the standard dynamic stochastic general equilibrium (DSGE) model used in macroeconomics is far too small and stable relative to empirical measures obtained from the data — an example of the “bond premium puzzle.” However, in models of endowment economie ..."
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Cited by 74 (4 self)
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The term premium on nominal longterm bonds in the standard dynamic stochastic general equilibrium (DSGE) model used in macroeconomics is far too small and stable relative to empirical measures obtained from the data — an example of the “bond premium puzzle.” However, in models of endowment economies, researchers have been able to generate reasonable term premiums by assuming that investors have recursive EpsteinZin preferences and face longrun economic risks. We show that introducing EpsteinZin preferences into a canonical DSGE model can also produce a large and variable term premium without compromising the model’s ability to fit key macroeconomic variables. Longrun real and nominal risks further improve the model’s ability to fit the data with a lower level of household risk aversion.
Crises and recoveries in an empirical model of consumption disasters. Working Paper 15920
, 2010
"... We estimate an empirical model of consumption disasters using a new panel data set on consumption for 24 countries and more than 100 years. The model allows for permanent and transitory effects of disasters that unfold over multiple years. It also allows the timing of disasters to be correlated acro ..."
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Cited by 63 (3 self)
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We estimate an empirical model of consumption disasters using a new panel data set on consumption for 24 countries and more than 100 years. The model allows for permanent and transitory effects of disasters that unfold over multiple years. It also allows the timing of disasters to be correlated across countries. We estimate the model using Bayesian methods. Our estimates imply that the average length of disasters is roughly 5 years and that more than half of the short run impact of disasters on consumption are reversed in the long run on average. We investigate the asset pricing implications of these rare disasters. In a model with power utility and standard values for risk aversion, stocks surge at the onset of a disaster due to agents ’ strong desire to save. This causes a low equity premium, especially in normal times. In contrast, a model with EpsteinZinWeil preferences and an intertemporal elasticity of substitution equal to 2 yields a sizeable equity premium in normal times for modest values of risk aversion.
An empirical evaluation of the longrun risks model for asset prices
 Critical Finance Review
, 2012
"... We provide an empirical evaluation of the LongRun Risks (LRR) model, and highlight important differences in the asset pricing implications of the LRR model relative to the habit model. We feature three key results: (i) consistent with the LRR model there is considerable evidence in the data for tim ..."
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Cited by 53 (8 self)
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We provide an empirical evaluation of the LongRun Risks (LRR) model, and highlight important differences in the asset pricing implications of the LRR model relative to the habit model. We feature three key results: (i) consistent with the LRR model there is considerable evidence in the data for timevarying expected consumption growth and consumption volatility, (ii) the LRR model matches the key asset markets data features, (iii) in the data and in the LRR model accordingly, lagged consumption growth does not predict the future pricedividend ratio, while in the habitmodel it counterfactually predicts the future pricedividend with an R 2 of over 40%. Overall, we find considerable empirical support for the LRR model.
Financial Markets and the Real Economy
, 2006
"... I survey work on the intersection between macroeconomics and finance. The challenge is to find the right measure of “bad times,” rises in the marginal value of wealth, so that we can understand high average returns or low prices as compensation for assets’ tendency to pay off poorly in “bad times.” ..."
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Cited by 43 (4 self)
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I survey work on the intersection between macroeconomics and finance. The challenge is to find the right measure of “bad times,” rises in the marginal value of wealth, so that we can understand high average returns or low prices as compensation for assets’ tendency to pay off poorly in “bad times.” I survey the literature, covering the timeseries and crosssectional facts, the equity premium, consumptionbased models, general equilibrium models, and labor income/idiosyncratic risk approaches.
The Term Structures of Equity and Interest Rates
, 2007
"... This paper proposes a dynamic riskbased model capable of jointly explaining the term structure of interest rates, returns on the aggregate market and the risk and return characteristics of value and growth stocks. Both the term structure of interest rates and returns on value and growth stocks conv ..."
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Cited by 37 (5 self)
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This paper proposes a dynamic riskbased model capable of jointly explaining the term structure of interest rates, returns on the aggregate market and the risk and return characteristics of value and growth stocks. Both the term structure of interest rates and returns on value and growth stocks convey information about how the representative investor values cash flows of different maturities. We model how the representative investor perceives risks of these cash flows by specifying a parsimonious stochastic discount factor for the economy. Shocks to dividend growth, the real interest rate, and expected inflation are priced, but shocks to the price of risk are not. Given reasonable assumptions for dividends and inflation, we show that the model can simultaneously account for the behavior of aggregate stock returns, an upwardsloping yield curve, the failure of the expectations hypothesis and the poor performance of the capital asset pricing model.
Evolution and intelligent design
 American Economic Review
, 2008
"... This paper discusses two sources of ideas that influence monetary policy makers today. The first is a set of analytical results that impose the rational expectations equilibrium concept and do ‘intelligent design ’ by solving Ramsey and mechanism design problems. The second is the adaptive learning ..."
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Cited by 33 (2 self)
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This paper discusses two sources of ideas that influence monetary policy makers today. The first is a set of analytical results that impose the rational expectations equilibrium concept and do ‘intelligent design ’ by solving Ramsey and mechanism design problems. The second is the adaptive learning process that first taught us how to anchor the price level with a gold standard, then how to replace the gold standard with a fiat currency wanting nominal anchors. Models of outofequilibrium learning say that such an adaptive evolutionary process will converge to a selfconfirming equilibrium (SCE). In an SCE, a government’s probability model is correct about events that occur under the prevailing government policy, but possibly wrong about the consequences of other policies. That causes mistakes absent from a rational expectations equilibrium and expands the role of learning.
The Term Structure of Interest Rates in a DSGE Model with Recursive Preferences
, 2010
"... We solve a dynamic stochastic general equilibrium (DSGE) model in which the representative household has Epstein and Zin recursive preferences. The parameters governing preferences and technology are estimated by means of maximum likelihood using macroeconomic data and asset prices, with a particul ..."
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Cited by 31 (2 self)
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We solve a dynamic stochastic general equilibrium (DSGE) model in which the representative household has Epstein and Zin recursive preferences. The parameters governing preferences and technology are estimated by means of maximum likelihood using macroeconomic data and asset prices, with a particular focus on the term structure of interest rates. We estimate a large risk aversion, an elasticity of intertemporal substitution higher than one, and substantial adjustment costs. Furthermore, we identify the tensions within the model by estimating it on subsets of these data. We conclude by pointing out potential extensions that might improve the model’s fit.
On the Need for a New Approach to Analyzing Monetary Policy ∗
, 2008
"... andUniversityofMinnesota We present a pricing kernel that summarizes well the main features of the dynamics of interest rates and risk in postwar U.S. data and use it to uncover how the pricing kernel has moved with the short rate. Our findings imply that standard monetary models miss an essential l ..."
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Cited by 24 (1 self)
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andUniversityofMinnesota We present a pricing kernel that summarizes well the main features of the dynamics of interest rates and risk in postwar U.S. data and use it to uncover how the pricing kernel has moved with the short rate. Our findings imply that standard monetary models miss an essential link between the central bank instrument and the economic activity that monetary policy is intended to affect, and thus we call for a new approach to monetary policy analysis. We sketch a new approach using an economic model based on our pricing kernel. The model incorporates the key relationships between policy and risk movements in an unconventional way: the central bank’s policy changes are viewed as primarily intended to compensate for exogenous business cycle fluctuations in risk that threaten to push inflation off target. This model, while an improvement over standard models, is considered just a starting point for their revision. The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System. Modern models of monetary policy start from the assumption that the central bank controls an asset price, namely, the short rate, as its policy instrument. In these models, this
Macroeconomics and the Term Structure
, 2010
"... This paper provides an overview of the analysis of the term structure of interest rates with a special emphasis on recent developments at the intersection of macroeconomics and finance. The topic is important to investors and also to policymakers, who wish to extract macroeconomic expectations from ..."
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Cited by 20 (1 self)
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This paper provides an overview of the analysis of the term structure of interest rates with a special emphasis on recent developments at the intersection of macroeconomics and finance. The topic is important to investors and also to policymakers, who wish to extract macroeconomic expectations from longerterm interest rates, and take actions to influence those rates. The simplest model of the term structure is the expectations hypothesis, which posits that longterm interest rates are expectations of future average shortterm rates. In this paper, we show that many features of the con…guration of interest rates are puzzling from the perspective of the expectations hypothesis. We review models that explain these anomalies using timevarying risk premia. Although the quest for the fundamental macroeconomic explanations of these risk premia is ongoing, in‡ation uncertainty seems to play a large role. Finally, while modern finance theory prices bonds and other assets in a single unified framework, we also consider an earlier approach based on segmented markets. Market segmentation seems important to understand the term structure of interest rates during the recent financial crisis.