Frequency of Consumption Adjustment and the Equity Premium

Abstract:     
We show that two types of consumption risk are priced in the equity premium: the risk of aggregate consumption growth and that of changing the composition of the consumption basket, when goods have heterogeneous costs of adjustment. We use the property that the frequency of consumption adjustment is inversely related to adjustment costs and split consumption into two components that proxy for consumption of low and high adjustment cost goods. We then estimate a version of the CCAPM with two components of consumption and show that our proposed split helps resolve the equity premium puzzle, while simultaneously generating sufficient volatility of marginal utility to satisfy volatility bounds at all frequencies.

Number of Pages in PDF File: 30

Keywords: equity premium puzzle, CCAPM, consumption adjustment costs

JEL Classification: G12

working papers series