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177
Macroeconomic priorities
 American Economic Review
, 2003
"... Macroeconomics was born as a distinct � eld in the 1940’s, as a part of the intellectual response to the Great Depression. The term then referred to the body of knowledge and expertise that we hoped would prevent the recurrence of that economic disaster. My thesis in this lecture is that macroeconom ..."
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Cited by 150 (0 self)
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Macroeconomics was born as a distinct � eld in the 1940’s, as a part of the intellectual response to the Great Depression. The term then referred to the body of knowledge and expertise that we hoped would prevent the recurrence of that economic disaster. My thesis in this lecture is that macroeconomics in this original sense has succeeded: Its central problem of depression prevention has been solved, for all practical purposes, and has in fact been solved for many decades. There remain important gains in welfare from better � scal policies, but I argue that these are gains from providing people with better incentives to work and to save, not from better � netuning of spending � ows. Taking
The Cost of Business Cycles under Endogenous Growth
, 2003
"... In his famous monograph, Lucas (1987) put forth an argument that the welfare gains from reducing the volatility of aggregate consumption are negligible. Subsequent work that revisited Lucas’ calculation continued to find only small benefits from reducing the volatility of consumption, further reinfo ..."
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Cited by 112 (4 self)
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In his famous monograph, Lucas (1987) put forth an argument that the welfare gains from reducing the volatility of aggregate consumption are negligible. Subsequent work that revisited Lucas’ calculation continued to find only small benefits from reducing the volatility of consumption, further reinforcing the perception that business cycles don’t matter. This paper argues instead that fluctuations can affect welfare by affecting the growth rate of consumption. I present an argument for why fluctuations can reduce growth starting from a given initial consumption, which could imply substantial welfare effects as Lucas (1987) already observed in his calculation. Empirical evidence and calibration exercises suggest that the welfare effects are likely to be substantial, about two orders of magnitude greater than Lucas’ original estimates.
A Quartet of SemiGroups for Model Specification, Detection, Robustness, and the Price of Risk
 Price of Risk,” University of Chicago manuscript
"... A representative agent fears that his model, a continuous time Markov process with jump and di#usion components, is misspecified and therefore uses robust control theory to make decisions. Under the decision maker's approximating model, that cautious behavior puts adjustments for model miss ..."
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Cited by 73 (26 self)
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A representative agent fears that his model, a continuous time Markov process with jump and di#usion components, is misspecified and therefore uses robust control theory to make decisions. Under the decision maker's approximating model, that cautious behavior puts adjustments for model misspecification into factor prices for risk. We use a statistical theory of detection to quantify the appropriate amount of model misspecification that the decision maker should fear. Related semigroups describe (1) an approximating model; (2) the behavior of model detection statistics; (3) a model misspecification adjustment to the continuation value in the decision maker's Bellman equation; and (4) asset prices.
The Market Price of Risk and the Equity Premium: A Legacy of the Great Depression
 Journal of Monetary Economics
, 2008
"... Friedman and Schwartz hypothesized that the Great Depression created exaggerated fears of economic instability. We quantify their idea by using a robustness calculation to shatter a representative consumer’s initial confidence in the parameters of a twostate Markov chain that truly governs consumpt ..."
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Cited by 70 (5 self)
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Friedman and Schwartz hypothesized that the Great Depression created exaggerated fears of economic instability. We quantify their idea by using a robustness calculation to shatter a representative consumer’s initial confidence in the parameters of a twostate Markov chain that truly governs consumption growth. The assumption that the consumption data come from the true Markov chain and the consumer’s use of Bayes ’ law cause that initial pessimism to wear off. But so long as it persists, the representative consumer’s pessimism contributes a volatile multiplicative component to the stochastic discount factor that would be measured by a rational expectation econometrician. We study how this component affects asset prices. We find settings of our parameters that make pessimism wear off slowly enough to allow our model to generate substantial values for the market price of risk and the equity premium. Key words: Robustness, learning, asset pricing. 1
Income and Wealth Heterogeneity, Portfolio Choice, and Equilibrium Asset Returns
 Macroeconomics Dynamics
, 1997
"... We derive assetpricing and portfoliochoice implications of a dynamic incompletemarkets model in which consumers are heterogeneous in several respects: labor income, asset wealth, and preferences. In contrast to earlier papers, we insist on at least roughly matching the model’s implications for he ..."
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Cited by 58 (1 self)
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We derive assetpricing and portfoliochoice implications of a dynamic incompletemarkets model in which consumers are heterogeneous in several respects: labor income, asset wealth, and preferences. In contrast to earlier papers, we insist on at least roughly matching the model’s implications for heterogeneity—notably, the equilibrium distributions of income and wealth—with those in U.S. data. This approach seems natural: Models that rely critically on heterogeneity for explaining asset prices are not convincing unless the heterogeneity is quantitatively reasonable. We find that the class of models we consider here is very far from success in explaining the equity premium when parameters are restricted to produce reasonable equilibrium heterogeneity. We express the equity premium as a product of two factors: the standard deviation of the excess return and the market price of risk. The first factor, as expected, is much too low in the model. The size of the market price of risk depends crucially on the constraints on borrowing. If substantial borrowing is allowed, the market price of risk is about one onehundredth of what it is in the data (and about 15 % higher than in the representativeagent model). However, under the most severe borrowing constraints
Fragile Beliefs and the Price of Model Uncertainty, working paper
, 2007
"... Concerns about misspecification and an enduring model selection problem in which one of the models has long run risks give rise to countercyclical risk premia. We use two risksensitivity operators to construct the stochastic discount factor for a representative consumer who evaluates consumption st ..."
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Cited by 53 (10 self)
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Concerns about misspecification and an enduring model selection problem in which one of the models has long run risks give rise to countercyclical risk premia. We use two risksensitivity operators to construct the stochastic discount factor for a representative consumer who evaluates consumption streams in light of model selection and parameter estimation problems that can aggravate or attenuate long run risks as time passes. The arrival of signals induces the consumer to alter his posterior distribution over models and parameters. The consumer copes with specification doubts by slanting probabilities pessimistically. These pessimistic model probabilities induce model uncertainty premia that contribute a timevarying component to what is ordinarily measured as the market price of risk.
Beliefs, Doubts, and Learning: Valuing Macroeconomic
 Risk, American Economic Review
, 2007
"... cover in this paper have been influenced by an extensive collaboration with Thomas Sargent. I greatly appreciate conversations with Xiaohong Chen, John Heaton, Ravi Jagannathan, Monika Piazzesi and Martin Schneider. I owe a special acknowledgement to Thomas Sargent and Grace Tsiang who provided many ..."
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Cited by 44 (6 self)
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cover in this paper have been influenced by an extensive collaboration with Thomas Sargent. I greatly appreciate conversations with Xiaohong Chen, John Heaton, Ravi Jagannathan, Monika Piazzesi and Martin Schneider. I owe a special acknowledgement to Thomas Sargent and Grace Tsiang who provided many valuable comments on preliminary drafts of this paper. Also I want to thank participants at workshops at NYU and Federal Reserve Bank of Chicago. Junghoon Lee and Ricardo Mayer provided expert research assistance. This material is based upon work supported by the National Science Foundation under Award Number SES0519372. This paper explores two perspectives on the rational expectations hypothesis. One perspective is that of economic agents in such a model, who form inferences about the future using probabilities implied by the model. The other is that of an econometrician who makes inferences about the probability model that economic agents are presumed to use. Typically it is assumed that economic agents know more than the econometrician, and econometric ambiguity is often withheld from the economic agents. To understand better both of these perspectives and the relation between them, I appeal to statistical decision theory to charac
Longrun risk through consumption smoothing
 Review of Financial Studies
, 2010
"... We examine how longrun consumption risk arises endogenously in a standard production economy model where the representative agent has EpsteinZin preferences. Even when technology growth is i.i.d., optimal consumption smoothing induces highly persistent timevariation in expected consumption growt ..."
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Cited by 42 (1 self)
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We examine how longrun consumption risk arises endogenously in a standard production economy model where the representative agent has EpsteinZin preferences. Even when technology growth is i.i.d., optimal consumption smoothing induces highly persistent timevariation in expected consumption growth (longrun risk). This increases the price of risk when investors prefer early resolution of uncertainty, and the model can then account for the low volatility of consumption growth and the high price of risk with a low coe ¢ cient of relative risk aversion. The asset price implications of endogenous longrun risk depends crucially on the persistence of technology shocks and investors preference for the timing of resolution of uncertainty.
An Equilibrium Guide to Designing Affine Pricing Models, Mathematical Finance forthcoming
, 2007
"... We examine equilibriummodels based on EpsteinZin preferences in a framework where exogenous state variables which drive consumption and dividend dynamics follow affine jump diffusion processes. Equilibrium asset prices can be computed using a standard machinery of affine asset pricing theory by im ..."
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Cited by 41 (13 self)
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We examine equilibriummodels based on EpsteinZin preferences in a framework where exogenous state variables which drive consumption and dividend dynamics follow affine jump diffusion processes. Equilibrium asset prices can be computed using a standard machinery of affine asset pricing theory by imposing parametric restrictions on market prices of risk, determined by preference and model parameters. We present a detailed example where large shocks (jumps) in consumption volatility translate into negative jumps in equilibrium prices of the assets. This endogenous ”leverage effect ” leads to significant premiums for outofthemoney put options. Our model is thus able to produce an equilibrium ”volatility smirk ” which realistically mimics that observed for index options. KEY WORDS: EpsteinZin preferences, affine asset pricing model, general equilibrium, option pricing ∗We thank two anonymous referees and the associate editor for valuable comments. We have also
Recursive Robust Estimation and Control Without Commitment
, 2006
"... In a Markov decision problem with hidden state variables, a posterior distribution serves as a state variable and Bayes ’ law under an approximating model gives its law of motion. A decision maker expresses fear that his model is misspecified by surrounding it with a set of alternatives that are nea ..."
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Cited by 41 (8 self)
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In a Markov decision problem with hidden state variables, a posterior distribution serves as a state variable and Bayes ’ law under an approximating model gives its law of motion. A decision maker expresses fear that his model is misspecified by surrounding it with a set of alternatives that are nearby when measured by their expected log likelihood ratios (entropies). Martingales represent alternative models. A decision maker constructs a sequence of robust decision rules by pretending that a sequence of minimizing players choose increments to a martingale and distortions to the prior over the hidden state. A risk sensitivity operator induces robustness to perturbations of the approximating model conditioned on the hidden state. Another risk sensitivity operator induces robustness to the prior distribution over the hidden state. We use these operators to extend the approach of Hansen and Sargent (1995) to problems that contain hidden states. 1