International portfolio diversification and labor/leisure choice

When marginal utility of consumption depends on leisure, investors will take this into account when allocating their wealth among different assets. This paper presents a multi-country general equilibrium model driven by productivity shocks, where labor-leisure and consumption are chosen endogenously. We use this framework to study the effect of leisure for optimal international diversification. We find that in the symmetric case the model's ability to help explain home-bias depends crucially on the level of substitutability between consumption and leisure.Saving and investment ; Econometric models

Quantitative asset pricing implications of endogenous solvency constraints

The authors study the asset pricing implications of an economy where solvency constraints are determined to efficiently deter agents from defaulting. The authors present a simple example for which efficient allocations and all equilibrium elements are characterized analytically. The main model produces large equity premia and risk premia for long-term bonds with low risk aversion and a plausibly calibrated income process. The authors characterize the deviations from independence of aggregate and individual income uncertainty that produce equity and term premia.Asset pricing

Using Asset Prices to Measure the Cost of Business Cycles

We propose a method to measure the welfare cost of economic fluctuations that does not require full specification of consumer preferences and instead uses asset prices. The method is based on the marginal cost of consumption fluctuations, the per unit benefit of a marginal reduction in consumption fluctuations expressed as a percentage of consumption. We show that this measure is an upper bound for the benefit of reducing all consumption fluctuations. We also clarify the link between the cost of consumption uncertainty, the equity premium, and the slope of the real term structure. To measure the marginal cost of fluctuations, we fit a variety of pricing kernels that reproduce key asset pricing statistics. We find that consumers would be willing to pay a very high price for a reduction in overall consumption uncertainty. However, for consumption fluctuations corresponding to business cycle frequencies, we estimate the marginal cost to be about 0.55% of lifetime consumption based on the period 1889-1997 and about 0.30% based on 1954-97.

Household Production and the Excess Sensitivity of Consumption to Current Income

Empirical research on the permanent income hypothesis (PIH) has found that consumption growth is excessively sensitive to predictable changes in income. This finding is interpreted as strong evidence against the PIH. We propose an explanation for apparent excess sensitivity that is based on a quantitative equilibrium version of Becker's (1965) model of household production in which permanent income consumers respond to shifts in sectoral wages and prices by substituting work effort and consumption across home and market sectors. Although the PIH is true, this mechanism generates apparent excess sensitivity because market consumption responds to predictable income growth.

Stock Market Boom and the Productivity Gains of the 1990s

Together with a sense of entering a New Economy, the U.S. experienced in the second half of the 1990s an economic expansion, a stock market boom, a financing boom for new firms and productivity gains. This article proposes an interpretation of these events within a general equilibrium model with financial frictions and decreasing returns to scale in production. We show that the mere prospect of high future productivity growth can generate sizable gains in current productivity, as well as the other above mentioned events

The International Diversification Puzzle is Worse Than You Think

Although international financial markets are highly integrated across the more well-developed countries, investors nevertheless hold portfolios that consist nearly exclusively of domestic assets. This violation of the predictions of standard theories of portfolio choice is known as the 'international diversification puzzle.' In this paper, we show that the presence of nontraded risk associated with variations in the return to human capital has dramatic implications for the optimal fraction of domestic assets in an individual's portfolio. Our analysis suggests that the returns to human capital are highly correlated with the returns to domestic financial assets. Hedging the risk associated with nontraded human capital involves a short position in national equities in an amount approximately 1.5 times the value of the national stock market. Thus optimal and value- weighted portfolios very likely involve a short position in domestic marketable assets.

Sticky Leverage

We develop a tractable general equilibrium model that captures the interplay between nominal long-term corporate debt, inflation, and real aggregates. We show that unanticipated inflation changes the real burden of debt and, more significantly, leads to a debt overhang that distorts future investment and production decisions. For these effects to be both large and very persistent, it is essential that debt maturity exceeds one period. We also show that interest rate rules can help stabilize our economy

Asset Pricing in Production Economies

This paper studies asset returns in different versions of the one-sector real business cycle model. We show that a model with habit formation preferences and capital adjustment costs can explain the historical equity premium and the average risk-free return while replicating the salient business cycle properties. The paper also applies a solution technique that combines loglinear methods with lognormal asset pricing formulae

Nontraded Goods, Nontraded Factors, and International Non-Diversification

Can the presence of nontraded consumption goods explain the high degree of 'home bias' displayed by investor portfolios? We find that the answer is no, so long as individuals have access to free international trade in financial assets. In particular, it is never optimal to exhibit home bias with respect to domestic traded-good equities. By contrast, an optimal portfolio may exhibit substantial home bias with respect to nontraded-good equities, although this result requires a very low degree of substitution between traded and nontraded goods in the utility function. Further, our analysis uncovers a second puzzle: the composition of investors' portfolios appears to be strongly at variance with the predictions of the model that incorporates nontraded goods.