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Ambiguity Aversion, the Equity Premium, and the Welfare Costs of Business Cycles
Yale University.
Stockholm University, Faculty of Social Sciences, Institute for International Economic Studies.
2007 (English)Report (Other academic)
Abstract [en]

We examine the potential importance of consumer ambiguity aversion for asset prices and how consumption fluctuations influence consumer welfare. First, considering a simple Mehra-Prescott-style endowment economy with a representative agent facing consumption fluctuations calibrated to match U.S. data, we study to what extent ambiguity aversion can deliver asset prices that are consistent with data: a high return on equity and a low return on riskfree bonds. For some configurations of preference parameters – a discount factor, a degree of relative risk aversion, and a measure of ambiguity aversion – we find that it can. Then, we use these parameter configurations to investigate how much consumers would be willing to pay to reduce endowment fluctuations to zero, thus delivering a Lucas-style welfare cost of fluctuations. These costs turn out to be very large: consumers are willing to pay over 10% of consumption in permanent terms.

Place, publisher, year, edition, pages
Stockholm: IIES , 2007. , 36 p.
Seminar Paper / Institute for International Economic Studies, Stockholm University. (Online), ISSN 1653-610X ; 752
National Category
URN: urn:nbn:se:su:diva-42240OAI: diva2:344497
Available from: 2010-08-19 Created: 2010-08-19 Last updated: 2010-08-19Bibliographically approved

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