The Case Against Power Utility and a Suggested Alternative: Resurrecting Exponential Utility

Utility modeled as a power function is commonly used in the literature despite the fact that it is unbounded and generates asset pricing puzzles. The unboundedness property leads to St. Petersburg paradox issues and indifference to compound gambles, but these problems have largely been ignored. The asset pricing puzzles have been solved by introducing habit formation to the usual power utility. Given these issues, we believe it is time re-examine exponential utility. Exponential utility was abandoned largely because it implies increasing relative risk aversion in a cross-section of individuals and nonstationarity of the aggregate consumption to wealth ratio, contradicting macroeconomic data. We propose an alternative preference specification with exponential utility and relative habit formation. We show that this utility function is bounded, consistent with asset pricing facts, generates near-constant relative risk aversion in a cross-section of individuals and a stationary ratio of aggregate consumption to wealth.unbounded utility, asset pricing puzzles, habit formation

Should Central Banks of Small Open Economies Respond to Exchange Rate Fluctuations? The Case of South Africa

We estimate a New Keynesian small open economy DSGE model for South Africa, using Bayesian techniques. The model features imperfect competition, incomplete asset markets, partial exchange rate pass-through, and other commonly used nominal and real rigidities, such as sticky prices, price indexation and habit formation. We study the effects of various shocks on macroeconomic variables, and calculate the optimal Taylor rule coefficients using a loss function for the central bank. We find that the optimal Taylor rule places a heavier weight on inflation and output than the estimated Taylor rule, but almost no weight on the depreciation of currency.optimal monetary policy, small open economy, Bayesian estimation

The Case Against Power Utility and a Suggested Alternative: Resurrecting Exponential Utility

Utility modeled as a power function is commonly used in the literature despite the fact that it is unbounded and generates asset pricing puzzles. The unboundedness property leads to St. Petersburg paradox issues and indifference to compound gambles, but these problems have largely been ignored. The asset pricing puzzles have been solved by introducing habit formation to the usual power utility. Given these issues, we believe it is time re-examine exponential utility. Exponential utility was abandoned largely because it implies increasing relative risk aversion in a cross-section of individuals and nonstationarity of the aggregate consumption to wealth ratio, contradicting macroeconomic data. We propose an alternative preference specification with exponential utility and relative habit formation. We show that this utility function is bounded, consistent with asset pricing facts, generates near-constant relative risk aversion in a cross-section of individuals and a stationary ratio of aggregate consumption to wealth

The Case Against Power Utility and a Suggested Alternative: Resurrecting Exponential Utility

Utility modeled as a power function is commonly used in the literature despite the fact that it is unbounded and generates asset pricing puzzles. The unboundedness property leads to St. Petersburg paradox issues and indifference to compound gambles, but these problems have largely been ignored. The asset pricing puzzles have been solved by introducing habit formation to the usual power utility. Given these issues, we believe it is time re-examine exponential utility. Exponential utility was abandoned largely because it implies increasing relative risk aversion in a cross-section of individuals and nonstationarity of the aggregate consumption to wealth ratio, contradicting macroeconomic data. We propose an alternative preference specification with exponential utility and relative habit formation. We show that this utility function is bounded, consistent with asset pricing facts, generates near-constant relative risk aversion in a cross-section of individuals and a stationary ratio of aggregate consumption to wealth