Consumption, the Persistence of Shocks, and Asset Price Volatility

Posted: 19 Nov 2007

Abstract

In a general equilibrium setting, a temporary component in consumption introduces a wedge between the volatility of equity returns and the volatility of consumption growth. This paper explores the asset pricing consequences of this property in a model in which consumption is the sum of a permanent and a transitory component. Permanent shocks are assumed to be rare events, while transitory shocks follow a diffusion process. When calibrated to US annual data, the model matches first and second moments of equity and bond returns for preference parameters within acceptable bounds. Permanent and transitory shocks together explain the equity premium, while transitory shocks alone explain the excess volatility of returns.

Keywords: Equity premium, volatility, transitory shocks

JEL Classification: G12, E21, C22

Suggested Citation

Rodriguez, Juan Carlos, Consumption, the Persistence of Shocks, and Asset Price Volatility. Journal of Monetary Economics, Vol. 53, No. 8, 2006. Available at SSRN: https://ssrn.com/abstract=1031061

Juan Carlos Rodriguez (Contact Author)

Tilburg University and CentER ( email )

P.O. Box 90153
Tilburg, 5000 LE
Netherlands
+31 13 466 3262 (Phone)
+31 13 466 2875 (Fax)

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