An Intertemporal Preference with Risk and Loss Aversion: Equilibrium Analysis

Abstract

We study a pure exchange economy with two groups of agents who exhibit different consumption patterns: one changes consumption immediately in response to shocks and the other exhibits stickiness in consumption change. This heterogeneity in the timing and the amount of consumption changes affects the equilibrium dynamics of wealth, and generates business cycles without a major shock to the endowment process. The model is fully tractable in that optimal allocations and the stationary densities of major asset pricing variables are obtained in closed form. The model generates counter-cyclical variation in risk aversion without having an external habit component in the utility function, by which we can explain why the Sharpe ratio, the risk premium, and the stock volatility are counter-cyclical and why the consumption-wealth (or price-dividend, inversely) ratio can predict future returns. The asset pricing moments and yield curves generated by the model match well with the data. Finally, the model also predicts that a (sudden) significant change in the government bond price is accompanied by major consumption revisions by households with sticky consumption without any change in the monetary policy.