An Intertemporal Preference with Loss Aversion: Equilibrium Analysis
52 Pages Posted: 8 Nov 2019 Last revised: 8 Dec 2019
Date Written: October 29, 2019
We study a pure exchange economy with heterogeneous agents -- a loss averse agent and a non-loss averse agent. We derive the equilibrium allocations and prices in closed-form. The loss averse agent exhibits loss aversion to consumption changes with the most recent consumption as a reference point. The equilibrium consumption of the loss averse agent displays consumption ratcheting and the ``catching up with Joneses effect" without having external habit formation in her preference. The model can explain a number of stylized facts in the consumption data, including the excess smoothness and excess sensitivity of consumption, and the asymmetric sensitivities to income shocks. The model generates dynamics of the stock and bond prices consistent with their cyclical behavior and asset pricing moments are well matched with data by using reasonable parameter values. Furthermore, the model generates upward sloping, flat and downward sloping yield curves.
Keywords: Utility Costs, Ratcheting, Intertemporal Loss Aversion, Competitive Equilibrium, Asset Pricing, Equity Premium, Term Structure of Interest Rates, Catching up with Joneses
JEL Classification: D11, E21, G11
Suggested Citation: Suggested Citation