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Institute for International Economic Studies, Stockholm University Seminar Papers, Institute for International Economic Studies, Stockholm University

No 752:
Ambiguity Aversion, the Equity Premium and the Welfare Costs of Business Cycles

Irasema Alonso () and Jr., Jose Mauricio Prado

Abstract: We examine the potential importance of consumer ambiguity aversion for asset prices and how consumption ‡fluctuations influence consumer welfare. First, considering a simple Mehra-Prescott-style endowment economy with a representative agent facing consumption fluctuations calibrated to match U.S. data, we study to what extent ambiguity aversion can deliver asset prices that are consistent with data: a high return on equity and a low return on riskfree bonds. For some configurations of preference parameters— a discount factor, a degree of relative risk aversion, and a measure of ambiguity aversion— we find that it can. Then, we use these parameter configurations to investigate how much consumers would be willing to pay to reduce endowment fluctuations to zero, thus delivering a Lucas-style welfare cost of fluctuations. These costs turn out to be very large: consumers are willing to pay over 10% of consumption in permanent terms.

Keywords: Ambiguity aversion; asset prices; business cycle; (follow links to similar papers)

JEL-Codes: D14; E32; G12; (follow links to similar papers)

36 pages, August 6, 2007

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