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Frequency of Consumption Adjustment and the Equity Premium

30 Pages Posted: 9 Feb 2012 Last revised: 10 Oct 2012

Narayan Bulusu

Bank of Canada

Javier Gómez Biscarri

Universitat Pompeu Fabra; Barcelona Graduate School of Economics (Barcelona GSE)

Date Written: February 8, 2012

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.

Keywords: equity premium puzzle, CCAPM, consumption adjustment costs

JEL Classification: G12

Suggested Citation

Bulusu, Narayan and Gómez Biscarri, Javier, Frequency of Consumption Adjustment and the Equity Premium (February 8, 2012). Paris December 2012 Finance Meeting EUROFIDAI-AFFI Paper. Available at SSRN: https://ssrn.com/abstract=2001646 or http://dx.doi.org/10.2139/ssrn.2001646

Narayan Bulusu (Contact Author)

Bank of Canada ( email )

234 Wellington St.
Ottawa, Ontario K1A 0G9
Canada

Javier Gómez Biscarri

Universitat Pompeu Fabra ( email )

Ramon Trias Fargas, 25-27
Barcelona, E-08005
Spain

Barcelona Graduate School of Economics (Barcelona GSE) ( email )

Ramon Trias Fargas, 25-27
Barcelona, Barcelona 08005
Spain

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