Consumption, Government Failure, and Asset Prices
46 Pages Posted: 26 Jun 2018 Last revised: 9 Oct 2019
Date Written: October 9, 2019
The equity premium-risk-free rate level and predictability puzzles in standard power utility consumption-based asset pricing models disappear once we remove the government-imposed component from the consumption expenditure series. I calibrate this component based on the growth rates of two proxies for government intervention, which I also show to forecast the short- and long-term equity premiums between 1974 (or 1981) and 2017. In summary, investors require large premiums to hold stocks because stocks deliver poor returns when government intervention (failure) increases, systematically reducing individual utility levels. Government failure is likely the key macro-finance variable linking asset prices and economic fluctuations.
Keywords: government failure, equity premium puzzle, intervention, regulation, risk
JEL Classification: G1, E1, H1
Suggested Citation: Suggested Citation