Consumption Heterogeneity and Long Run Risk

Abstract

This paper establishes a surprising and robust empirical similarity between short-run heterogeneous consumption and long-term consumption growth risk models. The models not only deliver a similar fit on a given set of portfolios, their actual pricing errors are also highly correlated. In addition, we find that consumption dispersion is a robust predictor of the transitory component in aggregate consumption growth. To interpret these findings, we propose a model in which aggregate uncertainty is a function of idiosyncratic uncertainty and only long-term consumption growth risk is priced. An implication of this being that consumption dispersion is priced empirically not because markets are necessarily incomplete but because investors disagree in the short-run about their common long-term consumption prospects.