Discussion Paper Details

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Title: Subjective Discount Factors

Author(s): Erzo G J Luttmer and Thomas Mariotti

Publication Date: July 2000

Keyword(s): Asset Pricing, Consumption-Wealth Ratios, General Equilibrium, Hyperbolic Discounting and Volatility

Programme Area(s): Financial Economics

Abstract: This paper describes the equilibrium of a discrete-time exchange economy in which consumers with arbitrary subjective discount factors and quasi-homothetic period utility functions follow linear Markov consumption and portfolio strategies. Explicit expressions are given for state prices and consumption-wealth ratios. If utility is logarithmic or endowment growth is i.i.d., then this economy is observationally equivalent to one in which consumers discount geometrically. We provide analytically convenient continuous-time approximations and examine the effects of non-geometric subjective discount factors in an economy in which log endowments are subject to temporary and permanent shocks that are governed by a Feller (1951) square-root process. Hyperbolic and quasi-hyperbolic discount factors can significantly increase the volatility of aggregate wealth and raise the expected excess return on aggregate wealth.

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Bibliographic Reference

Luttmer, E and Mariotti, T. 2000. 'Subjective Discount Factors'. London, Centre for Economic Policy Research.