Consumption-Based Asset Pricing When Consumers Make Mistakes

71 Pages Posted: 14 Jun 2021

See all articles by Chris Anderson

Chris Anderson

Board of Governors of the Federal Reserve System

Multiple version iconThere are 2 versions of this paper

Date Written: March, 2021

Abstract

I analyze the implications of allowing consumers to make mistakes on the risk-return relationships predicted by consumption-based asset pricing models. I allow for consumption mistakes using a model in which a portfolio manager selects investments on a consumer's behalf. The consumer has an arbitrary consumption policy that could reflect a wide range of mistakes. For power utility, expected returns do not generally depend on exposure to single-period consumption shocks, but robustly depend on exposure to both long-run consumption and expected return shocks. I empirically show that separately accounting for both types of shocks helps explain the equity premium and cross section of stock returns.

JEL Classification: G50, G51, G23, G12, G40, G11

Suggested Citation

Anderson, Christopher, Consumption-Based Asset Pricing When Consumers Make Mistakes (March, 2021). FEDS Working Paper No. 2021-015, Available at SSRN: https://ssrn.com/abstract=3865412 or http://dx.doi.org/10.17016/FEDS.2021.015

Christopher Anderson (Contact Author)

Board of Governors of the Federal Reserve System ( email )

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