Electronic copy available at: http://ssrn.com/abstract=1675271 Electronic copy available at: http://ssrn.

com/abstract=1675271


PLEASE SCROLL DOWN FOR ARTICLE
This article was downloaded by: [Yoshino, Joe Akira]
On: 19 August 2010
Access details: Access Details: [subscription number 915113283]
Publisher Routledge
Informa Ltd Registered in England and Wales Registered Number: 1072954 Registered office: Mortimer House, 37-
41 Mortimer Street, London W1T 3JH, UK
Applied Economics Letters
Publication details, including instructions for authors and subscription information:
http://www.informaworld.com/smpp/title~content=t713684190
Revisiting the interest rate puzzle
Joe Akira Yoshino
a
; Edson Bastos e Santos
b
a
Department of Economics, Universidade de So Paulo, So Paulo, Brazil
b
Department of Business
Administration, Universidade de So Paulo, So Paulo, Brazil
To cite this Article Yoshino, Joe Akira and e Santos, Edson Bastos(2009) 'Revisiting the interest rate puzzle', Applied
Economics Letters, 16: 13, 1333 1340
To link to this Article: DOI: 10.1080/17446540802403643
URL: http://dx.doi.org/10.1080/17446540802403643
Full terms and conditions of use: http://www.informaworld.com/terms-and-conditions-of-access.pdf
This article may be used for research, teaching and private study purposes. Any substantial or
systematic reproduction, re-distribution, re-selling, loan or sub-licensing, systematic supply or
distribution in any form to anyone is expressly forbidden.
The publisher does not give any warranty express or implied or make any representation that the contents
will be complete or accurate or up to date. The accuracy of any instructions, formulae and drug doses
should be independently verified with primary sources. The publisher shall not be liable for any loss,
actions, claims, proceedings, demand or costs or damages whatsoever or howsoever caused arising directly
or indirectly in connection with or arising out of the use of this material.
Electronic copy available at: http://ssrn.com/abstract=1675271 Electronic copy available at: http://ssrn.com/abstract=1675271
Revisiting the interest rate puzzle
Joe Akira Yoshino
a,
* and Edson Bastos e Santos
b
a
Department of Economics, Universidade de Sao Paulo,
Sao Paulo, 05508-010, Brazil
b
Department of Business Administration, Universidade de Sao Paulo,
Sao Paulo, 05508-010, Brazil
This article makes a connectionbetweenLucas (1978) asset pricing model and
the macroeconomic dynamics for some selected countries. Both the relative
risk aversion and the impatience for postponing consumption by synthesizing
the investor behaviour can help to understand some key macroeconomic
issues across countries, such as the savings decision and the real interest rate.
I find that the government consumption makes worse the so-called equity
premium-interest rate puzzle. The first root of the quadratic function for
explaining the real interest rate can produce this puzzle, but not the second
root. Thus, Mehra and Prescott (1985) identified only one possible solution.
I. Introduction
This work analyses the savings decision for some
selected countries (Brazil, Chile, China, India,
Mexico, South Korea and the USA).
The analysis uses Lucas (1978) asset pricing model.
Our work follows Cochrane and Hansens (1992) review
article. The key concept is due to Shiller (1982) and
Hansen and Jagannathan (1991). Weil (1989) pointed
out the risk-free rate part of the puzzle. We revisit the
latter issue here.
We find that the government consumption makes
worse the puzzle for all countries in terms of increasing
the relative risk aversion. On the other hand, this type
of complementary consumption has a positive effect
of smoothing out the growth rate of final consumption
(government consumption plus household consump-
tion) by reducing its variance with respect to the one of
household consumption (second-order effect).
Finally, we show that the two roots of the quadratic
equation that explains the real interest as a function of
both the growth rate of consumption (average and var-
iance) and the relative risk aversion can, respectively,
replicate and deny the equity premium-interest rate
puzzle.
This article is organized in the following way.
Section II illustrates the stylized facts by showing
some key macroeconomic variables across countries.
Section III makes the calibration of quadratic equa-
tion and Section IV analyses the real interest rates.
Finally, Section V contains the conclusions.
II. The Stylized Facts
Since the year 1960, some developing countries (China,
South Korea and Chile) have presented a sustainable
upward trend for the investment ratio [gross formation
of fixed capital/Gross Domestic Product (GDP)]. In
2004, for the first time in economic history, this rate has
reached unprecedented figures (44, 30 and 24% of the
GDP, respectively, in China, South Korea and Chile).
1
*Corresponding author. E-mail: pyoshino@usp.br
1
Source of data for the nominal interest rates and GDP deflator: International Financial Statistics, IFS/IMF. For each country,
we estimate the real interest rates in the following way: (i) USA, nominal interest rate of Treasury Bill 3 months minus inflation
(GDP deflator); (ii) Brazil, nominal interest rate of money market minus inflation (GDP deflator); (iii) Chile, nominal interest
rate of money market minus inflation (GDP deflator); (iv) China, nominal interest rate of Interbank Deposit Certificate (CDI)
minus inflation (deflator do PIB); (v) India, nominal interest rate of money market minus inflation (GDP deflator); (vi) Mexico,
nominal interest rate of central bank fund minus inflation (GDP deflator); and (vii) South Korea, nominal interest rate of
money market minus inflation (GDP deflator).
Applied Economics Letters ISSN 13504851 print/ISSN 14664291 online 2009 Taylor & Francis
http://www.informaworld.com
DOI: 10.1080/17446540802403643
1333
Applied Economics Letters, 2009, 16, 13331340
D
o
w
n
l
o
a
d
e
d

B
y
:

[
Y
o
s
h
i
n
o
,

J
o
e

A
k
i
r
a
]

A
t
:

1
8
:
4
3

1
9

A
u
g
u
s
t

2
0
1
0
On the other hand, another group of countries has
presented cyclical investments, more specifically,
decreasing in the recent years with average invest-
ment ratio of 21, 22 and 20% for Brazil, Mexico and
the USA, respectively. After linearly regressing the
investment ratio against a trend variable (time in
years), we corroborate our initial findings that the
trend variable coefficient is significant for all coun-
tries in the first group (p-value almost equals 0) and
that we cannot reject that the coefficient is 0 for
Brazil (p-value equals 0.87) and the USA (p-value
equals 0.29) and that conclusions are dubious with
respect to Mexico (p-value equals 0.04). These results
are due to the different choices of their populations
with respect to the flow of consumption over time.
Why do they behave so differently across countries?
Furthermore, the time series for final consumption/
GDP in China, South Korea, Chile and India has pre-
sented a downward trend.
2
In other words, a bigger
proportion of their productions may be channelled to
savings and, consequently, to productive investment, so
that the crowding-out effect does not happen. To have a
better understanding of the effects of consumption in the
formation of fixed capital, we pay attention to the two
components of the final consumption: (i) the government
consumptionand(ii) the household consumption. China
and South Korea have drastically reduced their house-
hold consumption, by 25 and 30% of the GDP, respec-
tively. The developing countries are increasing their
private savings. But, unfortunately, the government
consumption could waste part of these savings that
would be channelled to the productive investment.
Figure 1 illustrates the evolution of real interest
rates. The Brazilian economy has demanded enormous
interest rates (average, variances and peaks) during the
recent crises.
The stylized facts above pose the following questions:
Do the average real interest rates and the con-
sumption patterns across countries reflect their
relative risk aversions and impatience to post-
pone consumption?
Why does China behave so differently with respect
to other economies, specifically from Brazil?
In short, this work verifies whether a very simple
asset pricing model can provide a reasonable explana-
tion for the economic development.
III. Calibration
Based on the work of Lucas (1978), Cochrane (2005a,
p. 20) shows that
r
f.t
c E
t
ln C
t1

1
2

2
Var
t
ln C
t1
1
where r
f,t
=ln(1 + R
f,t
) and R
f,t
is the real interest rate;
c = -ln u captures the impatience to postpone
1960
0.2
0.15
0.1
0.05
0
0.05
0.1
0.15
0.2
1965 1970 1975 1980
Year
U
S
A
,

C
h
i
l
e
,

C
h
i
n
a
,

I
n
d
i
a

a
n
d

S
o
u
t
h

K
o
r
e
a

r
e
a
l

i
n
t
e
r
e
s
t

r
a
t
e

p
e
r

y
e
a
r
B
r
a
z
i
l

a
a
n
d

M
e
x
i
c
o

r
e
a
l

i
n
t
e
r
e
s
t

r
a
t
e

p
e
r

y
e
a
r
1985 1990 1995 2000 2005
1
0
1
2
3
4
5
6
7
USA
Chile
China
India
South Korea
Brazil
Mexico
Fig. 1. Evolution of real interest rates
2
Source of data for consumption (final consumption and household consumption) and GDP: World Bank National Accounts
Data; WDI World Development Indicators.
1334 J. A. Yoshino and E. B. Santos
D
o
w
n
l
o
a
d
e
d

B
y
:

[
Y
o
s
h
i
n
o
,

J
o
e

A
k
i
r
a
]

A
t
:

1
8
:
4
3

1
9

A
u
g
u
s
t

2
0
1
0
consumption and u is the subjective discount factor;
represents the relative risk aversion; C is the real
consumption per capita; is the difference operator,
i.e. ln C
t+1
= ln C
t+1
ln C
t
; E
t
and Var
t
are,
respectively, the expectation and variance conditioned
on the information set I
t
. Remark that E
t
( ln C
t+1
)
describes the expected growth rate of per capita real
consumption and Var
t
(ln C
t+1
) describes its variance
given I
t
. The model also assumes that ln C
t+1
is
normally distributed. Note that our analysis considers
two series of growth rates for per capita real
consumption: (i) final consumption and (ii) household
consumption. Here, the normality assumption is econ-
ometrically reasonable, because the data for all time
series do not reject the independently- and identically-
distributed hypothesis when we apply the Brock,
Dechert, Scheinkman and LeBaron (BDS) test
(adjusted for the bootstrap procedure for small
samples).
If we take expectations on both sides of Equation 1,
we obtain the unconditional representation of the
Lucas (1978) asset pricing model. Thus, we get
E r
f.t

c E E
t
ln C
t1

1
2

2
E Var
t
ln C
t1

c E ln C
t1

1
2

2
Var ln C
t1

Var E
t
ln C
t1
2
The second term on the RHS is obtained by the law of
iterated expectations, i.e. E(X) = E(E
t
(X)), and the third
term comes from the equivalence Var(X) = E(Var
t
(X))
Var(E
t
(X)). Now, our calibration depends on how we
estimate the variance of the conditional expectation
of the growth rate of per capita real consumption, i.e.
Var(E
t
(ln C
t+1
)). Fortunately, the log-normality
assumption of the consumption growth will lead us
to apply the Kalman filter, as it is the best linear and
nonlinear estimation of E
t
( ln C
t+1
) under this
framework.
Consider univariate ARMA (p,q) processes, i.e.
L ln C
t1
j L
t
3
where
L 1 c
1
L c
2
L
2
c
r
L
r

L 1 0
1
L 0
2
L
2
0
r1
L
r1

In the above equations, r = max {p,q + 1}, L
j
is the lag
operator, c
j
=0 for j .p and 0
j
= 0 for j .q. When we
apply the BoxJenkins methodology for the model
identification, we obtain the results shown in Table 1.
For most of the timeseries, the randomwalkis themost
plausible model, which implies that E
t
( ln C
t+1
) =
E(lnC
t+1
), i.e. the informationset I
t
has noprediction
value and therefore the unconditional expectation is
the best predictor of the conditional expectation. As a
result, when the series are random walks, the term
Var(E
t
(ln C
t+1
)) =Var(E(ln C
t+1
)) =0 because
E( ln C
t+1
) is nonstochastic. For some time series,
we have foundthat the informationset I
t
has the same
predictionvalue, and for these time series, we estimate
the model parameters considering Ordinary Least
Squares (OLS), Maximum Likelihood Estimation
(MLE) and Generalized Method of Moments
(GMM); see Tables 24.
It is easy to verify that all three estimation methods
seem to be equivalent. In addition, it is important to
remember that the GMM, despite its loss of efficiency
Table 2. Parameter estimation for expected growth rate of per
capita real final consumption in the USA
USA final consumption
Method j
c(L) =
1 c
1
L
(L)
= 1 Var(
t
)
MLE 2.1399 10
-2
1 0.4687L 1 1.5272 10
-4
OLS 2.1398 10
-2
1 0.4680L 1 1.5271 10
-4
GMM 1.8152 10
-2
1 0.4735L 1 1.5565 10
-4
Table 1. Models
Models for ln C
t +1
j
Time series Final consumption Household consumption
USA AR (1) MA (1)
Brazil Random walk Random walk
Chile Random walk Random walk
China Random walk MA (1)
India Random walk Random walk
South Korea Random walk Random walk
Mexico Random walk Random walk
Table 3. Parameter estimation for expected growth rate of
per capita real household consumption in the USA
USA household consumption
Method j c(L)
(L) =
1 + 0
1
L Var(
t
)
MLE 2.3751 10
-2
1 1 + 0.3790L 2.2169 10
-4
OLS 2.3375 10
-2
1 1 + 0.5615L 2.3517 10
-4
GMM 2.4329 10
-2
1 1 + 0.4842L 2.2589 10
-4
Interest rate puzzle 1335
D
o
w
n
l
o
a
d
e
d

B
y
:

[
Y
o
s
h
i
n
o
,

J
o
e

A
k
i
r
a
]

A
t
:

1
8
:
4
3

1
9

A
u
g
u
s
t

2
0
1
0
and the normality assumption, is the most robust
method of all three, and also the most preferable
among econometricians, and for convenience, we will
show only the results considering the GMM method.
Nevertheless, the results and conclusions that will be
shown further will be identical whatever the choice of
estimation method is considered. We may write
Equation 3 as a state-space representation. The result-
ing state-space and observation equations are
x
t1
F
t
v
t1
4
ln C
t1
j H
T

t1
5
where x
t
, H and v
t
are vectors of length r and F is a
square matrix of dimension r r, j is a scalar and
F
c
1
c
2
c
r1
c
r
1 0 0 0
0 1 0 0
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
0 0 1 0
2
6
6
6
6
6
6
4
3
7
7
7
7
7
7
5
. v
t

t
0
.
.
.
0
2
6
6
6
6
4
3
7
7
7
7
5
.
H
1
0
1
.
.
.
0
r1
2
6
6
6
6
4
3
7
7
7
7
5
Note that
t
,N 0. Var
t
is a white noise where
E(
t

t
) = 0 for t t. This implies that y
t
will also be
normally distributed, which is an assumption of the
Lucas (1978) model. As
t
is not serially autocorrelated,
Q E v
t
v
t
t


Var
t
0 0
0 0 0
.
.
.
.
.
.
.
.
.
.
.
.
0 0 0
2
6
6
4
3
7
7
5
Note that, when we substitute the estimated para-
meters (MLE, OLS and GMM estimates) in the
state-space representation given by Equations 4 and 5,
all the eigenvalues of F lie within the unit circle, and
therefore, F is stable and as a result
t
is covariance
stationary.
The predictor of ln C
t+1
conditioned to the infor-
mational set I
t
given the parameters estimates is
^
E
t
ln C
t1
j
^
E
t
H
t

t1
H
t
t
^
E
t

t1

where the operator E

t
() denotes the linear projection
of on the information set I
t
. As E

t
( ln C
t+1
) is
a functional of E

t
(
t+1
), we define the error covar-
iance as
P
t1jt
E
t1

^
E
t

t1

t1

^
E
t

t1

t

which may be written as a recursive Riccati equation,
i.e.
P
t1jt
FP
tjt1
F
t
FP
tjt1
HH
t
P
tjt1
H
1
FP
tjt1
H
t
Q
Now, we may collect Var(E
t
(ln C
t+1
)) from our
state-space representation as follows:
VarE
t
ln C
t1
VarE
t
ln C
t1
j
Var
^
E
t
ln C
t1
j
VarH
t
^
E
t

t1

H
t
Var
^
E
t

t1
H
Finally, we need to estimate Var(E

t
[
t+1
]); hence, we
may apply the Kalman filter on E

t
[
t+1
], which can be
equal to
^
E
t

t1
F
^
E
t1

t
K
t
ln C
t
j H
t
^
E
t1

where K
t
is r-vector representing the filter again, and it
is equal to
K
t
FP
tjt1
HH
t
P
tjt1
H
1
It is worthy to remark that F is stable, and, as a
consequence, P

lim
t!1
P
tjt1
will represent the
steady-state error covariance, which can be obtained
by solving the algebraic form of the Riccati equation:
P FPF
t
FPF H
t
PH
1
FPF
t
Q
As a consequence, the maximum gain that will be
obtained from the application of the linear filter is in
the steady state, i.e. K

lim
t!1
K
t
, or similarly,
Table 4. Parameter estimation for expected growth rate of
per capita real household consumption in China
China household consumption
Method j c(L)
(L) =
1 + 0
1
L Var(
t
)
MLE 7.0008 10
-2
1 1 + 0.5727L 5.1013 10
-4
OLS 7.0437 10
-2
1 1 + 0.2303L 5.8993 10
-4
GMM 6.5325 10
-2
1 1 + 0.5681L 5.1984 10
-4
1336 J. A. Yoshino and E. B. Santos
D
o
w
n
l
o
a
d
e
d

B
y
:

[
Y
o
s
h
i
n
o
,

J
o
e

A
k
i
r
a
]

A
t
:

1
8
:
4
3

1
9

A
u
g
u
s
t

2
0
1
0
K FPFH
t
PH
1
Tables 5 and 6 summarize the inputs, i.e. E(r
f,t
),
E( ln C
t+1
) and Var(E
t
( ln C
t+1
)), contemplated
in the calibration of the Lucas (1978) model pre-
sented in Equation 2. It is possible to verify that
modelling ln C
t+1
with an ARMA system we
improve our capacity of prediction by reducing the
uncertainty related to ln C
t+1
as Var( ln C
t+1
)
Var(E
t
(ln C
t+1
)) !0. It is important to remark that
the Kalman filter is relevant for the econometric
analysis just to corroborate that E

t
( ln C
t+1
) is the
best predictor (linear and nonlinear) under the nor-
mality assumption and Var(E

t
(ln C
t+1
)) will be the
smallest possible available information given set I
t
at
time period t.
IV. Analysis
Tables 5 and 6 present the data necessary to calibrate
Equation 2. Columns 3 and 4 show the real interest
rates expectation and variance, respectively. Brazil
has the biggest real interest rates during the period of
analysis, i.e. E(r
f,t
) = 0.133 per year and huge SD of

Varr
f.t

p
0.577 per year. By comparing column 6
of both tables, the addition of government consump-
tion to the household consumption has the positive
effect of decreasing the volatility of final consump-
tion relative to the one of household consumption;
this is easily seen in the Brazilian case, where Var(
ln C
t+1
) = 0.004 for household consumption and
Var( ln C
t+1
) = 0.0015 for final consumption.
Tables 7 and 8 show the following results:
(1) The quadratic equation 1 produces two roots
for the relative risk aversion. The first root gen-
erates the equity premium-interest rate puzzle
( ) 10), but not the second root ( ,10). This
phenomenon happens for all countries. Mehra
and Prescott (1985) found only one solution.
For instance, considering a reasonable utility
discount factor, i.e. u = 0.99, the USA has
two polar cases: (i) the nonpuzzle ( = 0.46
second root of Equation 2) and (ii) the puzzle
( ) 10 first root).
(2) According to line 2 of Table 7 (second root and
without puzzle), the lower relative risk aversion
coefficients happen for Chile ( = 0.08), China
( = 0.10), India (0.15), Mexico (0.27) and
Table 5. Summary of inputs used for calibration of real final consumption time series
(1) (2) (3) (4) (5) (6) (7)
Country Period
E(r
f,t
)
(10
-2
)
Var(r
f,t
)
(10
-4
)
E( ln C
t+1
)
(10
-2
)
Var( ln C
t+1
)
(10
-4
)
Var(E
t
( ln C
t+1
))
(10
-4
)
USA 19642002 1.9686 3.6555 2.0861 1.9428 0.4566
Brazil 19612003 13.3027 3325.9135 2.1727 14.9989
Chile 19772003 0.2391 0.4424 3.0514 38.4997
China 19802003 0.6842 13.5112 7.0591 6.9291
India 19612003 0.2872 28.2300 1.9535 5.0568
Mexico 19752003 0.3174 116.6850 1.1881 14.7448
South Korea 19772003 3.7422 10.7762 4.7105 15.5843
Table 6. Summary of inputs used for calibration of real household consumption time series
(1) (2) (3) (4) (5) (6) (7)
Country Period
E(r
f,t
)
(10
-2
)
Var(r
f,t
)
(10
-4
)
E( ln C
t+1
)
(10
-2
)
Var( ln C
t+1
)
(10
-4
)
Var(E
t
( ln C
t+1
))
(10
-4
)
USA 19642002 1.9686 3.6555 2.4038 2.5578 0.5406
Brazil 19612003 13.3027 3325.9135 2.3410 34.6274
Chile 19772003 0.2391 0.4424 3.4470 48.9864
China 19802003 0.6842 13.5112 6.9504 7.5974 1.6891
India 19612003 0.2872 28.2300 1.7406 6.0378
Mexico 19752003 0.3174 116.6850 1.1647 17.2351
South Korea 19772003 3.7422 10.7762 4.8278 22.5656
Interest rate puzzle 1337
D
o
w
n
l
o
a
d
e
d

B
y
:

[
Y
o
s
h
i
n
o
,

J
o
e

A
k
i
r
a
]

A
t
:

1
8
:
4
3

1
9

A
u
g
u
s
t

2
0
1
0
South Korea (0.81). The USA ( = 0.95) has
a bigger relative risk aversion coefficient, but
it is still much smaller than the one for Brazil
(8.79). Figure 2 illustrates these cases for sev-
eral countries as a function of average real
interest rates.
3
(3) Investors in the USA are risk averse only when
u ! 0.99 (case for , 10, i.e. the second root).
In a similar way, except for South Korea and
Brazil, all other countries require a utility dis-
count factor of u = 1, so that in these countries
investors are very patient for postponing
Table 7. Relative risk aversion and utility discount factor for final consumption time series
u Roots USA Brazil Chile China India Mexico South Korea
(1) 1.00 First 174.4800 20.1832 15.7726 123.7455 77.1142 15.8441 59.6463
(2) Second 0.9488 8.7887 0.0788 0.0970 0.1473 0.2718 0.8052
(3) 0.99 First 174.9657 21.2579 16.0985 123.8879 77.6273 16.6752 59.8647
(4) Second 0.4631 7.7139 -0.2472 -0.0454 -0.3657 -0.5593 0.5868
(5) 0.98 First 175.4536 22.1929 16.4150 124.0315 78.1387 17.4402 60.0837
(6) Second -0.0248 6.7789 -0.5637 -0.1890 -0.8772 -1.3244 0.3678
(7) 0.97 First 175.9438 23.0342 16.7232 124.1762 78.6488 18.1544 60.3033
(8) Second -0.5149 5.9376 -0.8719 -0.3337 -1.3873 -2.0386 0.1482
(9) 0.96 First 176.4362 23.8075 17.0240 124.3220 79.1577 18.8281 60.5236
(10) Second -1.0074 5.1643 -1.1727 -0.4795 -1.8961 -2.7122 -0.0721
(11) 0.94 First 177.4285 25.2081 17.6064 124.6173 80.1723 20.0809 60.9662
(12) Second -1.9997 3.7637 -1.7551 -0.7748 -2.9107 -3.9651 -0.5148
(13) 0.92 First 178.4309 26.4710 18.1672 124.9174 81.1838 21.2384 61.4119
(14) Second -3.0020 2.5008 -2.3159 -1.0749 -3.9222 -5.1225 -0.9604
(15) 0.90 First 179.4439 27.6369 18.7102 125.2227 82.1932 22.3245 61.8609
(16) Second -4.0151 1.3349 -2.8589 -1.3802 -4.9316 -6.2087 -1.4094
(17) 0.85 First 182.0276 30.2709 20.0087 126.0099 84.7149 24.8230 62.9998
(18) Second -6.5988 -1.2991 -4.1574 -2.1674 -7.4534 -8.7071 -2.5483
(19) 0.80 First 184.6928 32.6520 21.2483 126.8344 87.2469 27.1183 64.166
(20) Second -9.2640 -3.6801 -5.397 -2.9919 -9.9853 -11.0025 -3.7145
Table 8. Relative risk aversion and utility discount factor for household consumption time series
u Roots USA Brazil Chile China India Mexico South Korea
(1) 1.00 First 160.7892 6.7605 + 5.5793i 14.0036 182.8673 57.4928 13.2367 41.9995
(2) Second 0.8231 6.7605 5.5793i 0.0697 0.0985 0.1655 0.2783 0.7897
(3) 0.99 First 161.2105 6.7605 + 5.0323i 14.2921 183.0120 58.0677 14.0817 42.2146
(4) Second 0.4018 6.7605 5.0323i -0.2188 -0.0461 -0.4095 -0.5666 0.5747
(5) 0.98 First 161.6338 6.7605 + 4.4114i 14.5724 183.1579 58.6373 14.8460 42.4295
(6) Second -0.0215 6.7605 4.4114i -0.4999 -0.1920 -0.9790 -1.3310 0.3597
(7) 0.97 First 162.0592 6.7605 + 3.6792i 14.8453 183.3050 59.2018 15.5510 42.6445
(8) Second -0.4469 6.7605 3.6792i -0.7719 -0.3392 -1.5435 -2.0360 0.1447
(9) 0.96 First 162.4868 6.7605 + 2.7479i 15.1116 183.4534 59.7617 16.2101 42.8595
(10) Second -0.8745 6.7605 2.7479i -1.0383 -0.4876 -2.1035 -2.6951 -0.0703
(11) 0.94 First 163.3488 8.9074 15.6274 183.7542 60.8692 17.4244 43.2899
(12) Second -1.7364 4.6137 -1.5541 -0.7884 -3.2109 -3.9093 -0.5007
(13) 0.92 First 164.2222 10.8873 16.1241 184.0605 61.9622 18.5362 43.7209
(14) Second -2.6077 2.6337 -2.0508 -1.0947 -4.3040 -5.0212 -0.9317
(15) 0.90 First 165.1011 12.2126 16.6051 184.3725 63.0433 19.5733 44.1530
(16) Second -3.4888 1.3085 -2.5318 -1.4066 -5.3850 -6.0582 -1.3638
(17) 0.85 First 167.3505 14.6813 17.7554 185.1789 65.7065 21.9421 45.2400
(18) Second -5.7382 -1.1602 -3.6821 -2.2131 -8.0483 -8.4271 -2.4508
(19) 0.80 First 169.6741 16.6476 18.8537 186.0267 68.3356 24.1046 46.3413
(20) Second -8.0618 -3.1265 -4.7804 -3.0609 -10.6773 -10.5896 -3.5520
3
Figure 2 plots Equation 2 assuming both u = 0.99 and the data of each country: real interest rate (expectation) and final
consumption (expectation, variance and variance of conditional expectation) that are reported in Table 5.
1338 J. A. Yoshino and E. B. Santos
D
o
w
n
l
o
a
d
e
d

B
y
:

[
Y
o
s
h
i
n
o
,

J
o
e

A
k
i
r
a
]

A
t
:

1
8
:
4
3

1
9

A
u
g
u
s
t

2
0
1
0
consumption. South Korean and Brazilian
investors require u = 0.97 and 0.88, respec-
tively. Therefore, the latter two investors are
the most impatient for delaying consumption,
which requires bigger real interest rate to induce
themto save. This result is reported by Cochrane
(2005a).
(4) For u ! 0.95, Brazilian investor shows complex
roots in Equation 2, i.e. = b
2
4ac , 0. In
addition, the information set I
t
does not help in
the prediction of ln C
t+1
, i.e. Var(E
t
( ln
C
t+1
)) = 0, which implies E( ln C
t+1
)
2
,2 (ln
u + E(r
f,t
)) Var( ln C
t+1
). Despite the highest
expected growth of consumption E( ln C
t+1
)
and the lowest utility discount factor u in the
Brazilian case, this latter inequality condition is
satisfied, especially, due toboth the huge volatility
of consumption Var( ln C
t+1
) and big expected
real interest rate E(r
f,t
).
(5) By adding the government consumption to the
household consumption, the puzzle becomes
worse ( becomes bigger in the first root), in
particular.
(6) Brazil has the biggest real interest rate (average
of 13.3% per year) across countries due to (i)
their enormous relative risk aversion ( = 8.8
in the second root for the final consumption,
when u = 1); (ii) the big per capita growth rate
of consumption (2.2% per year); and (iii) the
highest impatience for postponing consumption
(u = 0.88). As a consequence, Brazil has a
sluggish economy, given that the local investors
are very risk averse and impatient.
(7) Chinese investor has a very low relative risk
aversion coefficient ( = 0.1 in the second
root without puzzle case when u = 1).
Given these conditions, this country presents
the following results: the lowest household
consumption (52% of GDP) is seen across
countries, their expected real interest rate is
small (less than 1% per year), the investment
rate is impressive (the gross formation of
fixed capital as percentage of GDP is 45%)
and the growth rate of per capita household
consumption is about 7% per year (world-
wide record).
(8) Finally, Fig. 3 illustrates the complexity of
Equation 1 for the USA by using the data from
Mehra and Prescott (1985). This figure provides
two possible solutions for the USA: puzzle and
nonpuzzle cases. The key assumption here is the
log-normality and stationarity of time series.
Otherwise, the analysis is not so simple.
V. Conclusions
This work makes a very simple application of metho-
dology suggested by Cochrane (2005b) to understand
0
5
10
R
e
l
a
t
i
v
e

r
i
s
k

a
v
e
r
s
i
o
n

(

)
15
20
25
30
35
40
Brazil
India
United States
South Korea
China
Nonpuzzle region
Puzzle region
Chile
Mexico
Real interest rate (r
f,t
)
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8
Fig. 2. Relative risk aversion and interest rate for final consumption time series
Interest rate puzzle 1339
D
o
w
n
l
o
a
d
e
d

B
y
:

[
Y
o
s
h
i
n
o
,

J
o
e

A
k
i
r
a
]

A
t
:

1
8
:
4
3

1
9

A
u
g
u
s
t

2
0
1
0
the macroeconomic dynamics in some developing
countries compared with that of the USA.
The government consumption has the positive effect
of smoothing out the volatility of final consumption
when it is compared with the one of household con-
sumption. On the other hand, the puzzle becomes worse
when government consumption is added to household
consumption to compose the final consumption.
The Chinese investors have the smallest relative risk
aversion coefficient and the lowest impatience for
postponing consumption. The consequences are as
follows: (i) the smallest consumption ratio (52% of
GDP); (ii) their annual real interest is only 0.7% in
comparison with 2% in the USA, in the period 1961 to
2002; (iii) the Chinese recent investment rate (gross
formation of physical capital) is the worldwide record
(45% of GDP); and (iv) the average growth rate of per
capita consumption is also the greatest (7% per year).
On the other hand, the Brazilian investors have the
biggest relative risk aversion coefficient and the high-
est impatience for delaying consumption, which
makes their economy the least dynamic.
Given the quadratic equation for the real interest
rate as a function of relative risk aversion and growth
of the consumption (average and variance), the second
root does not produce the equity premium-interest
rate puzzle, but the first root does. This issue can
provide a great explanation for the economic develop-
ment process. The main conclusion of this article is
that the puzzle problem is just the nonidentification of
the other possible solution.
This work is amazingly simple and clear, but the
content is cool. In terms of further directions, we men-
tion some caveats in this work. First, the key assump-
tions are the log-normality and the stationary properties
of time series. If these assumptions are not satisfied, the
estimation can become very cumbersome. Another pro-
blem is that the model here does not consider the huge
volatility of real interest rates. Thus, in the real world,
there is not such a thing as a risk-free interest rate.
References
Cochrane, J. H. (2005a) Asset Pricing, Revised edn,
Princeton University Press, Princeton, NJ.
Cochrane, J. H. (2005b) Financial markets and the real
economy, NBER Working Paper No. 11193, National
Bureau of Economic Research, Inc., Cambridge, MA.
Cochrane, J. H. and Hansen, L. P. (1992) Asset pricing
explorations for macroeconomics, NBER Working
Paper No. 4088, National Bureau of Economic
Research, Inc., Cambridge, MA.
Hansen, L. P. and Jagannathan, R. (1991) Implications of
security market data for models of dynamic economies,
Journal of Political Economy, 99, 22562.
Lucas Jr, R. E. (1978) Asset prices in an exchange economy,
Econometrica, 46, 192946.
Mehra, R. and Prescott, E. (1985) The equity premium: a
puzzle, Journal of Monetary Economics, 15, 14561.
Shiller, R. J. (1982) Consumption, asset markets and macro-
economic fluctuations, NBER Working Paper No. 838,
National Bureau of Economic Research, Inc.,
Cambridge, MA.
Weil, P. (1989) The equity premium puzzle and the risk-free
rate puzzle, Journal of Monetary Economics, 24, 40121.
50
0.005
0
0.005
G
r
o
w
t
h

r
a
t
e

o
f

c
o
n
s
u
m
p
t
i
o
n
0.01
0.015
0.02
0.025
0.03
0.035
0.04 R
e
a
l

i
n
t
e
r
e
s
t

r
a
t
e
0
0.01
0.02
0.03
0.04
Puzzle region
Nonpuzzle region
Nonpuzzle solution
Second root
of quadratic equation (1)
Mehra and Prescott (1985)
Puzzle solution:
first root of quadratic equation (1)
40
30
20
10
R
elative risk aversion
0
10
Fig. 3. Surface: real interest rate, consumption and relative risk aversion
1340 J. A. Yoshino and E. B. Santos
D
o
w
n
l
o
a
d
e
d

B
y
:

[
Y
o
s
h
i
n
o
,

J
o
e

A
k
i
r
a
]

A
t
:

1
8
:
4
3

1
9

A
u
g
u
s
t

2
0
1
0