A Parsimonious Macroeconomic Model for Asset Pricing: Habit Formation of Cross-sectional Heterogeneity?

In this paper we study asset prices in a parsimonious two-agent macroeconomic model with two key features: limited participation in the stock market and heterogeneity in the elasticity of intertemporal substitution in consumption. The parameter values for the model are taken from the business cycle literature, and in particular, are not calibrated to match financial statistics. The model generates a number of asset pricing phenomena that have been documented in the literature, including a high equity premium and a low risk-free rate; procyclical variation in the price-dividend ratio; countercyclical variation in the equity premium, in its volatility, and in the Sharpe ratio; and long- horizon predictability of returns with high R2 values. We also show that the similarity of our results to those from an external habit model is not a coincidence: the model has a reduced form representation that is similar to Campbell and Cochrane’s (1999) framework for asset pricing. However, the implications of the two models for macroeconomic questions and policy analyses are different.