Parameter Learning in Production Economies
65 Pages Posted: 22 Aug 2018 Last revised: 8 Jan 2024
Date Written: January 27, 2021
Abstract
We examine how parameter learning amplifies the impact of macroeconomic shocks on equity prices and quantities in a standard production economy where a representative agent has Epstein-Zin preferences. An investor observes technology shocks that follow a regime-switching process but does not know the underlying model parameters governing the short-term and long-run perspectives of economic growth. We show that rational belief updating endogenously generates long-run risks that help explain various asset pricing facts, most prominently, dividend yield variance decomposition. The asset pricing implications of endogenous long-run risks depend crucially on the introduction of a procyclical dividend process.
Keywords: Parameter learning, dividend yield variance decomposition, return predictability, business cycles, Markov switching
JEL Classification: D83, E13, E32, G12
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