A Household’s Preferences Vary Depending on Whether Incomes Are Permanent or Temporary: A Solution to the Time-Inconsistency Problem and Equity-Premium Puzzle

Abstract

A household’s preferences are usually assumed not to vary temporally or depending on the objects to which they are applied, but this assumption is often inconsistent with empirical estimates, for example, with the time-inconsistency problem of the time preference rate and the equity-premium puzzle. I show that these inconsistencies are generated because a household’s preferences vary depending on whether they are applied to permanent or temporary incomes. Preferences applied to permanent incomes are anchored to the steady state or a balanced growth path, but those for temporary incomes are not. Hence, the former is fixed and unchanged, but the latter can take various values depending on conditions.