Asset Pricing in an International Lucas Orchard with Dynamic Learning and Catching up with the Joneses under Agents’ Heterogeneous Expectations and Preferences

Abstract

This paper studies asset pricing wherein the model combines dynamic learning and habit formation with agents’ heterogeneous beliefs and preferences in a dynamic, stochastic, general-equilibrium, pure-exchange, international Lucas orchard. The intertemporal equilibrium model considers two groups of agents who have heterogeneous expectations about the future economic growth of two/N international goods and an indicator of the aggregate growth rate in the international economy. Additionally, the agents differ in both, with respect to preferences for the subjective rate of time preference and in the level of risk aversions. Further, the agents have different preferences, different demands and different habit formation across goods. The fundamental dynamics of the economies are modeled with full interaction across evolutions. The model provides semi-closed-form solutions for the state price densities, optimal consumptions, market prices of risk, interest rates and exchange rates, volatilities of interest rates, exchange rate volatility and asset prices as well as optimal portfolio choices. The asset pricing is based on functional integration under dynamic learning using spectral factorization techniques. The results of the paper allow identifying how international agents’ heterogeneity in beliefs and preferences under learning and catching up with the Joneses are reflected in equilibrium co-movements of asset returns within international financial markets. It is shown that the learning agents will survive in the long run, that the riskless rate is at lowest when both agents are pessimistic and compare to constant beliefs the interest rate and interest rate volatility can be even lower, whereas the exchange-rate volatility exceeds the figures in the corresponding model with non-learning agents. These effects are even stronger under habit formation. The results are further improvements to the interest-rate and exchange rate puzzle. Further, general equilibrium applications with multiple goods in international financial markets and nominal pricing within international monetary economics are discussed