Interest Rates and Asset Prices

Martin Ellison

MPhil Macroeconomics, University of Oxford

1 Introduction
The course so far has concentrated in how macroeconomic variables, such as consumption,
investment, output and inflation evolve over time. Our efforts have focussed on characterising
the dynamics in these variables and trying to understand the underlying forces which produce
these fluctuations. Aside from references to interest rates we have made little mention of
financial variables. Earlier lectures introduced money into our standard models but the focus
in this lecture is on financial variables, e.g. stock prices, bond prices, interest rates, the
term structure of interest rates, etc. In particular we will extend our analysis to see what
implications our neoclassical model has for these real financial variables. The use of neoclassical
models to analyse financial variables has generally been seen as less controversial than the same
program aimed at economic variables. Many economists believe that goods and credit markets
contain fundamental imperfections that make the neoclassical analysis irrelevant. However, at
least until recently it is widely perceived that financial markets come closest to approximating
the “ideal” market structure of neoclassical macroeconomics. However, as we shall see the
performance of the neoclassical model in explaining financial variables is little better than in
explaining economic variables.

2 Key readings
The assigned reading for this lecture is Romer Chapter 7. The seminal paper in this literature
is Lucas (1978) “Asset Prices in an Exchange Economy” Econometrica but this is an extremely
demanding read which I would not expect you to even try. The seminal assessment of the
theory is Mehra and Prescott (1985) “The equity premium: A puzzle” Journal of Monetary

1
Economics. A useful article which offers a general overall framework is Campbell (1986) “Bond
and Stock Returns in a Simple Exchange Model” Quarterly Journal of Economics which after
several careful readings may help to clarify matters.

3 Key concepts
Equity Premium, Term Structure, Consumption CAPM, Asset Pricing Models

4 Econometric evidence
The crucial link in economic models of asset pricing is between consumption and rates of
return. If an individual is to invest in an asset they have to be prepared to defer some
consumption now for consumption in the future. Therefore at the core of economic models of
asset prices is a link between consumption growth and rates of return. Table 1 shows some
basic facts regarding US consumption, the return on US Treasury 90 day bills (a relatively
safe short term security), the return on the US stock market and the difference between the
equity return and the return on the Treasury Bill (called the equity premium).

2
 Cons Return Return Equity
growth T bills stocks premium
Mean S.D. Mean S.D. Mean S.D. Mean S.D.
1889-
1.83 3.57 0.80 5.67 6.98 16.54 6.18 16.67
1978
1889-
2.30 4.90 5.80 3.23 7.58 10.02 1.78 11.57
1898
1899-
2.55 5.31 2.62 2.59 7.71 17.21 5.08 16.86
1908
1909-
0.44 3.07 -1.63 9.02 -0.14 12.81 1.49 9.18
1918
1919-
3.00 3.97 4.30 6.61 18.94 16.18 14.64 15.94
1928
1929-
-0.25 5.28 2.39 6.50 2.56 27.90 0.18 31.63
1938
1939-
2.19 2.52 -5.82 4.05 3.07 14.67 8.89 14.23
1948
1949-
1.48 1.00 -0.81 1.89 17.49 13.08 18.30 13.20
1958
1859-
2.37 1.00 1.07 0.64 5.58 10.59 4.50 10.17
1968
1969-
2.41 1.40 -0.72 2.06 0.03 13.11 0.75 11.64
1978
Table 1: Consumption and Rates of Return
(from Mehra and Prescott, JME, 1985)

The numbers clearly differ between decades and in the case of both consumption growth
and treasury bills there is some evidence that volatilities have declined over time. However,
the following facts stand out:
(i) Consumption growth displays relatively small volatility, ranging between -0.25% and
3% with a standard deviation of 3.57
(ii) Equities are more volatile than short term bonds (with a standard deviation around
three times larger)

3
 (iii) In every single decade investors earned a higher return on equities than they did on
short term bonds. Over the whole period the equity premium was on average 6.2%, with the
short term interest rate being 0.8% and the return on equities 7%

5 Consumption Capital Asset Pricing Model

In Lecture 1 we examined the consumer’s intertemporal first order condition (EC). This was:

U ′ (ct ) = Et βU ′ (ct+1 )Rt+1 (1)

where U ′ (·) denotes the marginal utility of consumption, R is the rate of return on an asset
and β is the discount factor. The intuition behind this expression is very simple. A consumer
is deciding whether to forego one unit of consumption now and instead purchase one unit of an
asset which will yield an uncertain return R next period and enable the consumer to have R
extra units of consumption next period. The consumer will choose their consumption/assets
so that the marginal utility of today’s consumption is equal to what an extra unit of the
asset would yield in utility next period. Notice that if rates of return are positive then
U ′ (ct+1 ) < U ′ (ct ) and so consumption is increasing over time (U ′′ (·) < 0). Equation (1) tells
us something about the joint determination of rates of return and consumption, alternatively
we could think of (1) as explaining consumption growth for a given rate of return (as we did
in Lecture 1) or as explaining rates of return for a given path of consumption, as we shall do
now.
If a consumer has more than one asset that they can invest in, equation (1) must hold
for each and every asset. For each asset the consumer has to equate the loss from foregone
consumption with the gain from additional consumption in the next period which depends
upon the asset rate of return. Consider an economy where there are two assets, it must be
the case that:
U ′ (ct ) = Et βU ′ (ct+1 )R1t+1
(2)
U ′ (ct ) = Et βU ′ (ct+1 )R2t+1
Assume that asset 1 is a “safe” asset while asset 2 is risky. By “safe” we mean that the
return on asset 1 is known one period in advance. From (2) we have:

0 = Et U ′ (ct+1 ) (R2t+1 − R1t+1 )

(3)
0 = Et U ′ (ct+1 )Et (R2t+1 − R1t+1 ) + cov(U ′ (ct+1 ), (R2t+1 − R1t+1 ))

4
where we have used the result that E(XY ) = E(X)E(Y ) + cov(X, Y ). Because asset 1 is a
safe asset we know that Et R1t+1 = R1t+1 also because it is safe it involves no risk/uncertainty
and so displays no covariance with U ′ (ct+1 ). Therefore we can re-write (3) as:

cov(U ′ (ct+1 ), R2t+1 )

Et R2t+1 = R1t+1 − (4)
Et U ′ (ct+1 )

Equation (4) is at the heart of the Consumption CAPM model and it says that if the rate
of return on a risky asset is positively correlated with the marginal utility of consumption
then that asset will earn a lower rate of return than the safe asset. In contrast, assets which
have a negative correlation with marginal utility will earn a greater return than the safe asset.
remembering that marginal utility is decreasing in consumption, this implies that assets which
tend to pay a high return when consumption is low earn a lower average rate of return, whereas
assets which pay a high return when consumption is high earn above average rates of return.
Why? Effectively an asset which pays a high rate of return when consumption is low acts as an
insurance policy. When consumption is low, marginal utility is high and agents would like to
have more income to spend - in other words when a bad event happens you would ideally like
an insurance policy that pays out. Therefore assets which have a positive covariance between
their rate of return and marginal utility offer insurance benefits. As a result agents will be
prepared to hold them even if they earn a lower rate of return than other assets. By contrast,
assets with a negative covariance have their highest rates of return when consumption is high,
therefore to be persuaded to hold these assets their rate of return has to be higher than other
assets.

5.1 Equity prices

We can also use (1) to draw some implications about equity prices. In particular we will show
how under certain assumptions we can express an equity price as a discounted sum of future
dividends. The return on equity is given by (pt+1 + dt+1 )/pt where p is the price of a share
and d is the dividend payment received by the share. Therefore re-writing (1) and using our
expression for E(XY ) we have:


′ 
′ 
pt+1 + dt+1 U (ct+1 ) U (ct+1 ) pt+1 + dt+1
1 = βEt Et + βcov , (5)
pt U ′ (ct ) U ′ (ct ) pt

To derive a simple equation for equity prices we need to make very strong assumptions.
Firstly, we need to assume that the covariance term in (5) is zero and secondly we also need

5
to assume that the expectation of the ratio of marginal utilities is constant. For this to be
true we require that the utility function is linear (e.g. U (C) = α + δC). In this case U ′ (c) = δ
and so Et U ′ (ct+j ) = δ ∀ j. If we make these assumptions then (5) can be written as:
pt
Et (pt+1 + dt+1 ) = (6)
β
which says that when allowance is made for discounting and dividends then the share price is
unpredictable - a variant of the famous random walk result. Moreover, we can use recursive
forward substitution to re-write this equation as:
∞

pt = β j Et dt+j (7)
j=1

so that the current share price is equal to the present discounted value of all future expected
dividends. Equation (7) is a much-tested implication of various asset pricing models. To see
how we move from (6) to (7), re-write (6) as:

pt = βEt pt+1 + βEt dt+1

But the same expression for t + 1 gives:

pt+1 = βEt+1 pt+2 + βEt+1 dt+2

so by substitution we have:

pt = βEt (βEt+1 pt+2 + βEt+1 dt+2 ) + βEt dt+1

= β 2 Et pt+2 + βEt dt+1 + β 2 Et dt+2

If we continually substitute for Et pt+j we arrive at (6) - the equity price reflects the dis-
counted stream of future dividends. Notice however the extreme assumptions we have made
to arrive at (7) - the covariance term being set to zero and the utility function being linear.
Neither of these assumptions can be empirically justified and without them it is not the case
that the equity price equals the present discounted value of future dividends.

5.2 Term structure

Equation (1) can also be generalised to assets which involve more than one period of investment
(i.e. two year bonds). Consider a consumer who is deciding whether to invest in a j period

6
bond which will earn return Rjt over the next j periods. The same logic as we used for
equation (1) tells us that the consumer will equate the lost utility from lower consumption
this period with higher consumption gained in j periods’ time so that the Euler equation is:
 ′

j U (ct+j )
Et β Rjt = 1 (8)
U ′ (ct )

At any moment in time the term structure is defined as {R1t , R2t , . . . Rnt }, in other words
a sequence of interest rates on bonds of different maturities. The term structure is extremely
important to policymakers and financial markets as it reveals what the market expects the
future interest rate to be, e.g. the difference between R2t (the return on a two year bond)
and R1t (the return on a one year bond) must contain information on what interest rates
will be in year 2. This idea forms the basis of the expectations theory of the term structure.
This theory basically says R2t = R1t Et R1t+1 in other words investors must earn the same
return from investing in a two year bond as they expect to earn from investing in a one year
bond now and then reinvesting the proceeds in a one year bond next year. This theory has
been thoroughly tested and its strict implications found not to hold. While the term structure
does tell us something about future rates the correlation is not perfect. To see this consider
equation (8) where j = 2 and we have slightly re-written the equation so that:

1 U ′ (ct+1 ) U ′ (ct+2 )
= Et β ′ β (9)
R2t U (ct ) U ′ (ct+1 )
An important statistical result is the Law of Iterated Expectations or LIE. This says that
Et (Et+1 Xt+1+j ) = Et Xt+1+j . While LIE looks foreboding it is actually a very simple result.
It says that if we are to forecast today what we think our forecast will be of a variable in the
future, then our best forecast of tomorrow’s forecasts is simply our current forecast. We can
therefore use this result to re-write (9) as:
′ ′
1
R2t
= Et β UU(c′ (ct+1
t)
) U (ct+2 )
β U ′ (ct+1 )
′ ′
1
R2t
= Et β UU(c′ (ct+1
t)
)
Et+1 β UU ′ (ct+2 )
(ct+1 )
(10)
′
1
R2t
= Et β UU(c′ (ct+1
t)
) −1
R1t+1

where we have again used (8) for j = 1 in the last line. Equation (10) is a generalised
version of the expectations theory of the term structure. If the covariance term is zero (which
would happen if U (·) were linear) then (10) is exactly the standard expectations model of
the term structure - the return on a two year bond equals the return on a one year bond
times the expected return on a one year bond next period. However, more generally there

7
is a covariance term reflecting the fact that the consumer dislikes uncertainty. The intuition
behind the covariance term is not surprisingly similar to that in the consumption CAPM. If
′ −1
Ut+1 /Ut′ and R1t+1 are negatively correlated then the one period bond tends to pay a high
rate of return when the marginal utility of consumption is high. If this is the case then the
return on a two year bond must be greater than from simply investing in two consecutive one
year bonds, to compensate the consumer from losing this insurance effect. This is exactly
−1 −1 −1
what (10) says, if the covariance term is negative then R2t < R1t Et R1t+1 implying that R2t
is greater.
While (1) tells us something about the term structure we need to make more specific
assumptions if we are able to say anything more precise about the slope of the term structure
- that is do interest rates on bonds increase or decrease with maturity?
Assume that the utility function is given by constant relative risk aversion (CRRA) so that
U (c) = c1−σ /(1 − σ). In this case we can write (8) as:

−σ 
j ct+j
Et β Rjt = 1 (11)
ct

Before we can say anything precise about the term structure we need to make one more
assumption, and that is that consumption growth and interest rates are distributed jointly
log normal. This is a standard trick in modern macro and often leads to very tractable
analytical expressions. What does it mean? If X is distributed log normal then log(Et X) =
Et log X + σ 2 /2, where σ is the standard deviation of log X. It should be stressed that
this assumption of joint log-normality does have economic implications. We are essentially
assuming something about the tastes and technology of the economy and the type of economic
fluctuations they produce. If we apply this formula to (11) and re-arranging we have that:
1
ln Rjt = −j ln β + σEt ln(ct+j /ct ) − var(−σ ln(ct+j /ct )) (12)
2
Assuming that on average consumption grows by η per period we can then use (12) to
calculate an average one year interest rate associated with a j period bond.
ln Rjt 1
= − ln β + ση − var(−σ ln(ct+j /ct )) (13)
j 2j
Equation (13) says that the average yield on a j period bond depends on three terms: the
discount rate, mean consumption growth and a variance term. The first reflects the discount
rate. Because β < 1, ln β < 0 and so the yield on a j period bond is increasing in the discount
factor. The intuition behind this is simple - consumers discount the future and so place less

8
weight on the future marginal utility of consumption. Therefore in order to persuade the
consumer to hold a bond the rate of return needs to at least match the rate of time preference.
However, this effect is the same for bonds of all maturities and so does not affect the slope of
the term structure (the term structure being a plot of essentially ln Rjt /j against j.
The second term is the expected average consumption growth over the next j periods. If
consumption is expected to grow strongly over the next j periods then the ratio of marginal
utility in j periods time and now will be less than 1. Therefore the greater this consumption
growth, the higher the j period interest rate needs to be to persuade agents to give up even
more consumption today in return for higher t + j consumption. We have assumed that
consumption growth is expected to be the same 1,2 or j years out. However, this need not
be the case. For instance, at the bottom of a recession consumption growth over the next
few years can be expected to be higher than over the next 20 years. Therefore from (13) the
average yield on short term bonds should exceed that on 20 year bonds in the depth of a
recession.
The final term reflects the variance of consumption growth. If consumers are not char-
acterised by certainty equivalence then increases in uncertainty affect their behaviour. The
CRRA utility function does not display certainty equivalence and so uncertainty has an im-
portant role to play. Here an increase in uncertainty causes the bond rate to fall, because
the greater the uncertainty the more that consumers value the certain payoff provided by the
bond. Whether the term structure is upward or downward sloping depends on whether the
numerator or denominator of the third term increases the most with the maturity j. Since
consumption growth in US data is positively autocorrelated, we would expect the numerator
to rise faster than the denominator. In other words, this model delivers a downward sloping
term structure. This is contrary to the upward-sloping term structure usually observed in
data. Intuitively, the term structure slopes downwards in the model for insurance reasons.
Suppose that consumption growth is subject to a negative shock sometime between periods
t and t + j. The worsening outlook for consumption growth will cause interest rates to fall,
which implies that the long bond will increase in price. Consumers will therefore have a capital
gain with which to offset their reduced consumption. Therefore bonds offer a hedge against
consumption risk. From (13) we can see that the greater the uncertainty there is about j pe-
riod ahead consumption the lower the return on a j period bond. Once again this is because
consumers are willing to earn a lower return on bonds because of the hedging characteristics
they offer. Those of you who are interested in how well stochastic dynamic general equilibrium

9
models succeed in reproducing the observed behaviour of the term structure would do well to
read Wouter den Haan “The term structure of interest rates in real and monetary economies”,
Journal of Economic Dynamics and Control 1995, pp. 909-940.
The final term reflects the variance of consumption growth, rates of return and the covari-
ance between them. If consumers are not characterised by certainty equivalence then increases
in uncertainty affect their behaviour. The CRRA utility function does not display certainty
equivalence and so uncertainty has an important role to play. Once again the reason why
uncertainty influences the rate of return is for insurance reasons. To see this consider the case
where consumption growth over the next j periods is expected to be low. From our earlier
analysis we know this implies that rates of return over the next j periods will be low. For a
bond this implies that bond prices will be relatively high. Conversely if consumption growth
is expected to be high bond prices will be relatively low. Therefore bonds offer a hedge against
consumption risk. From (13) we can see that the greater the uncertainty there is about j pe-
riod ahead consumption the lower the return on a j period bond. Once again this is because
consumers are willing to earn a lower return on bonds because of the hedging characteristics
they offer. Those of you who are interested in how well stochastic dynamic general equilibrium
models succeed in reproducing the observed behaviour of the term structure would do well to
read Wouter den Haan “The term structure of interest rates in real and monetary economies”,
Journal of Economic Dynamics and Control 1995, pp. 909-940.

6 Lucas Asset Pricing Model

While the last section gave a number of insights regarding the relationship between consump-
tion, rates of return and uncertainty it was not a general equilibrium analysis. We tended to
move between treating consumption as a given and then seeing what determined rates of re-
turn or fixing rates of return and analysing what happens to consumption. However, what we
really want to analyse is the joint determination of both. Unfortunately this requires numerical
simulations for plausible economic models. However, Lucas (1978) offers a very abstract model
which avoids the problem. In the Lucas model the only form of capital are trees which bear
fruit. Unfortunately the fruit produced by these trees can only be used for consumption and
not investment purposes. Therefore in this economy output must equal consumption (output
is simply the crop of fruit). From period to period the crop varies randomly (presumably
because of weather). The idea here is to interpret the tree as an asset which yield a dividend

10
stream for all future periods (the dividends being the crop) and the question is what price to
attach to the asset. The questions Lucas tries to answer are actually more ambitious than this
explanation might suggest. What Lucas was trying to arrive at were asset pricing formulae.
That is given certain information about the economy, i.e. value of productivity shocks, capital
stock, etc. how could you convert these into a formula for determining asset prices. Further,
Lucas was interested in asset pricing rules which formed a Rational Expectations Equilibrium.
That is if everyone used these asset pricing rules then everyone would choose appropriate
capital stocks and consumption such that the prices predicted by these pricing rules actually
materialised. However, we shall consider only very simple examples of the Lucas paper.
The return to holding a tree is (pt+1 + dt+1 )/pt where d is dividends (crop) and p is the
price of the tree. Our usual Euler equation (1) holds so that:


′ 
pt+1 + dt+1 U (ct+1 )
Et β =1
pt U ′ (ct )
Because the fruit is perishable it must be the case that each period the crop is consumed
(dt = ct ) so that we can re-write this equation as:

′ 
U (dt+1 )
pt = Et β (pt+1 + dt+1 ) (14)
U ′ (dt )
If we use this equation to keep substituting out pt+j on the right hand side we eventually
arrive at the results that: ∞
 U ′ (dt+j )
pt = Et βj ′ dt+j (15)
j=1
U (dt )
This is a simple generalisation of (6) so that the asset price is still equal to the discounted
sum of future dividends but now the consumer uses a discount rate which depends upon the
marginal utility of consumption. In this model when dividends are high they are give a lower
weight (U ′ (d) is low) because consumption is already high and the high output is not valued so
highly compared to a low output situation. If we make the strong assumption that U (c) = ln c
then (15) becomes:
∞

pt = Et β j dt
j=1
or (16)
β
pt = dt
1−β
In other words, the share price simply depends upon today’s dividend. This is an extreme
case but (16) gives an example of an asset pricing function (i.e. feed in today’s dividend

11
and out comes equity price) and also illustrates how this function crucially depends upon the
utility function. The reason why (16) depends only on current dividends is due to the fact
that future dividends are discounted completely. Announcements of future dividends have two
effects: firstly, they increase the price of the share, secondly they increase future discount rates.
In this simple logarithmic model these two facts example cancel out leaving the share price to
depend only on current dividends. Notice that even though the equity price depends only on
the current dividend the model is completely forward looking and characterised by Rational
Expectations. Therefore even though most of the underlying model is the same we arrive at a
very different result from (6). This in part justifies Lucas’ focus on asset pricing rules - clearly
asset prices will differ strongly under different assumptions about the underlying economy.

7 Empirical evidence
In Lecture 1 we briefly discussed some empirical rejections of (1) (consumption being pre-
dictable by income, the fact that the serial correlation properties of rates of return and con-
sumption are very different). However, here we shall discuss less the failures of the model
with respect to consumption but to rates of return uncertainty. The Mehra and Prescott
(1985) paper takes a very simple Lucas asset pricing model and calculates plausible values of
uncertainty, risk aversion and consumption and asks what the model predicts for the riskless
rate of return and the equity premium. In the data the equity premium is over 6% but they
find that for a variety of models and assumptions the consumption CAPM cannot generate
an equity premium higher than 0.4%. In other words, the model fails miserably to generate
enough excess return in equity. To give the intuition behind this result let utility be of the
CRRA form, i.e. U (c) = c1−σ /(1 − σ) where σ is the coefficient of relative risk aversion.
Given the lack of variability in consumption growth shown in Table 1, to explain large equity
premiums it is necessary to assume very large amounts of risk aversion so that σ is a large
number (around 60-80 whereas in the data it appears to be between 1 and 5). In other words,
to explain why risky assets earn such a high rate of return when there is not much risk in the
economy you have to assume agents are extremely risk averse and would prefer not to hold
risky assets. However, from (1) and using our CRRA assumption we can write:
1
∆ ln ct = α + Rt + ut (17)
σ
Interpreting Rt as the return on the safe asset we can see the problem. To explain the high
equity premium σ needs to be very large, but then (17) says that to understand consumption

12
growth of 1.88% per annum we require R/σ to be large. But if R is small (which Table 1
shows it is) and σ is large then we cannot explain the observed magnitude of consumption
growth (the α in (17) is also small). In other words, if we explain the high equity premium by
high risk aversion we have another problem - why is the risk free rate so low? Whereas if we
explain the low risk free rate by lower values of σ the equity premium puzzle resurfaces, why
do consumers need to be rewarded so much to hold equities?
A number of proposal have been examined for explaining the equity premium. Here I
briefly discuss three of them.

7.1 Preferences
The first is to change the specification of the utility functions. Two popular strands here are
to introduce habits and also to move away from expected utility theory.

7.1.1 Non-expected utility theory

We explain the equity premium via (17). However, the term 1/σ in (17) is the intertemporal
elasticity of substitution. In other words it tells us how much consumption a consumer is
willing to reallocate between time periods in response to the interest rate, When we assume
CRRA the intertemporal elasticity of substitution is the inverse of the coefficient of relative
risk aversion. More generally whenever the utility function satisfies expected utility theory
there is an inverse relationship between the intertemporal elasticity and risk aversion. This is
an unfortunate restriction as risk aversion and the intertemporal elasticity measure to different
things. Risk aversion is about how agents compare consumption in different states of the world
whereas intertemporal substitution is about how agents compare consumption at different
points in time. In response to this a number of people (i.e. Epstein and Zin (1989) Journal of
Political Economy) have investigated non-expected utility functions which do not impose this
inverse relationship between risk aversion and intertemporal substitution. While non-expected
utility has gone some way to solving the equity premium and risk free puzzle its success has
been limited. Firstly, while estimates of risk aversion from this approach are higher than with
standard expected utility models they are still not high enough to explain the extent of the
equity premium. Explaining the equity premium simply requires counterfactually high risk
aversion. Secondly, estimates of the intertemporal elasticity of substitution are approximately
the same regardless of whether you use expected or non-expected utility. Therefore the low
risk free rate puzzle remains.

13
7.1.2 Habits

Constantinides (1990) Journal of Political Economy shows that the equity premium and risk
free rate puzzles can be explained by assuming habits in the utility function and without
recourse to very high levels of risk aversion. The effect of introducing habits is that utility
depends not just upon current consumption but also recent consumption. For instance, a
CRRA utility function with habits would be:
1
(ct − φct−1 )1−σ (18)
1−σ
where φ reflects the importance of habits. In the presence of habits consumers have even more
reason to want to smooth.
Equation (1) reveals that the key variable for rates of return is the Marginal Rate of
Substitution (MRS), that is the ratio of marginal utilities. In the absence of habits, marginal
utility just depends n current consumption. However, in the case of habits marginal utility
depends on consumption in several periods and so becomes more volatile. This makes the
MRS more volatile as well as returns and depending on the degree of risk aversion can explain
a large equity premium. The trick here is simple - Table 1 tells us that consumption isn’t very
volatile. Therefore to explain the equity premium via a volatile MRS we must make sure that
marginal utility does not just depend on current consumption.
As this explanation makes clear this habit-based explanation seems an excellent candidate
for explaining the two asset market anomalies. However, as shown in Boldrin, Christiano and
Fisher (“Asset Pricing Lessons for Modelling Business Cycles” American Economic Review
2001) this is only partly the case. In the case of an endowment economy (without any capital)
habit-based utility functions can explain the equity premium and the risk free puzzle. However,
once production and a labour supply choice is introduced this is no longer the case. The reason
why this is the case is quite straightforward. In the production model with capital and a labour
supply decision agents have additional ways of smoothing their marginal utility. For instance,
when output is high they can choose to invest more rather than raise consumption and similarly
if consumption is high they can work harder by taking less leisure. All of these actions serve
to reduce the volatility of the MRS and so go against explaining the equity premium.

7.2 Market structure

The Mehra-Prescott (1985) paper examines a general equilibrium model where all markets
are open. Therefore one reason why the model predictions might fail is that some markets

14
are not open. For instance, some consumers may be unable to borrow. If this is the case
then a consumer’s consumption will be correlated with their income in every period, and as a
result there will be some individual specific income risks which will influence an individual’s
consumption. If there existed perfect borrowing opportunities or insurance possibilities then
these idiosyncratic income risks would not influence consumption.
The introduction of borrowing constraints can explain both the low risk free rate and
the high equity premium. The risk free rate is the interest rate which ensures equilibrium
in the deposit/loan market, that is where savings equals loans. However, if an economy
is characterised by borrowing constraints then loans made are very small and so to ensure
equilibrium in the deposit market it must be the case that savings are also small. The only
way this can be achieved is by having very low interest rates. Therefore in an economy with
borrowing constraints the risk free rate is very low (see Huggett (1993) Journal of Economic
Dynamics and Control). Borrowing constraints can also explain high values of the equity
premium. Because of borrowing constraints individual consumption is more volatile than
it otherwise would have been. This is because individual specific income risks cannot be
diversified away through borrowing. Therefore consumers are already bearing more risk than
they would like to if there were complete markets. Therefore in order to take on even more
risk by holding equity they need to be rewarded with very high rates of return.
Borrowing constraints/incomplete markets have therefore always been seen as the most
likely explanation for the equity premium puzzle. However, this claim has been questioned.
Telmer (1993) Journal of Finance and D. Lucas (1994) Journal of Monetary Economics both
examine the effect that various incomplete market assumptions have on the risk free rate and
the equity premium. They find that only if borrowing opportunities are completely absent is
it possible to explain the equity premium puzzle. Basically these papers find that agents only
need access to one asset which they can sell short (borrow) over some range (i.e. there is still
a borrowing constraint) for them to be able to avoid large amounts of diversifiable risk. In
other words, markets need to be seriously incomplete to explain the equity premium puzzle.
If only a few asset markets are open this still enables asset prices to approximate very closely
those predicted by a complete markets representative agent model1 .
1
However, Heaton and Lucas (Journal of Political Economy 1996 “Evaluating the effects of incomplete
markets on risk sharing and asset prices”) suggests that if transaction costs are large in asset markets and
also agents face persistent idiosyncratic shocks then a substantial proportion of the equity premium can be
explained.

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7.3 Immobile factors of production
Boldrin, Christiano and Fisher (2001 American Economic Review) argue that habits combined
with immobile factors of production can explain asset market puzzles. To understand why this
is the case it is useful to return to the model with habits in the endowment economy. Boldrin
et al identify two features which any model must possess in order to explain asset market
puzzles. The first is that consumers must have frequent motivation to buy and sell assets in
order to smooth consumption. The second is that for some reason consumers desire to trade
assets is restricted. In the endowment economy with habits both these features are present.
Because of habit formation marginal utility is very volatile and so for a given consumption
variability the stronger are habits the more consumers wish to trade in assets. However, in
an endowment economy there is a fixed supply of capital. As a consequence variations in
the demand for assets lead to large changes in asset prices. As a consequence this model can
explain asset price puzzles. However as soon as we introduce production into the model the
supply of capital becomes perfectly elastic and asset prices hardly change at all in response to
demand variations. Hence the production model with habits cannot explain the asset market
puzzles.
Armed with this intuition Boldrin et al argue that the way to explain the asset market
puzzles in the context of a production economy with habits is to introduce some rigidities
which frustrate the desire of consumers to trade in assets. In order to do this they introduce
a two sector economy: one sector produces capital goods and the other consumer goods. To
introduce rigidities they assume that the capital employed in each sector needs to be chosen in
advance. As a consequence capital cannot move between sectors immediately in the aftermath
of a shock. To introduce additional frictions they also assume that the labour employed in
each sector has to be fixed in advance. Their simulations suggest that these modifications go
a significant way to explaining asset price puzzles.

8 Conclusion
We have shown how the neoclassical model links consumption (not output) and rates of return
on different assets and how particular importance is place on risk and covariance. These are
extremely elegant theories which have been widely used in the finance literature. However, as
was the case for the neoclassical model’s ability to explain non-financial variables the model
fails on a number of important empirical dimensions. Understanding these failures is the

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subject of much research but as yet no clear consensus regarding how to proceed has been
achieved.

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