Extreme Inflation and Time-Varying Expected Consumption Growth
65 Pages Posted: 2 Sep 2016 Last revised: 3 Mar 2021
Date Written: April 2, 2019
In a parsimonious regime switching model, we find strong evidence that expected consumption growth varies over time. Adding inflation as a second variable, we uncover two states in which expected consumption growth is low, one with high and one with negative expected inflation. Embedded in a general equilibrium asset pricing model with learning, these dynamics replicate the observed time variation in stock return volatilities and stock-bond return correlations. They also provide an alternative derivation for a measure of time-varying disaster risk suggested by Wachter (2013), implying that both the disaster and the long-run risk paradigm can be extended towards explaining movements in the stock-bond correlation.
Keywords: Long-run risk, inflation, recursive utility, filtering, disaster risk
JEL Classification: E31, E44, G12
Suggested Citation: Suggested Citation