DP2503 Subjective Discount Factors

Author(s):	Erzo G J Luttmer, Thomas Mariotti
Publication Date:	July 2000
Keyword(s):	Asset Pricing, Consumption-Wealth Ratios, General Equilibrium, Hyperbolic Discounting, Volatility
JEL(s):	D50, D91, G12
Programme Areas:	Financial Economics
Link to this Page:	cepr.org/active/publications/discussion_papers/dp.php?dpno=2503

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.