Chapter 19 Asset prices, consumption, and the business cycle

This chapter reviews the behavior of financial asset prices in relation to consumption. The chapter lists some important stylized facts that characterize US data, and relates them to recent developments in equilibrium asset pricing theory. Data from other countries are examined to see which features of the US experience apply more generally. The chapter argues that to make sense of asset market behavior one needs a model in which the market price of risk is high, time-varying, and correlated with the state of the economy. Models that have this feature, including models with habitformation in utility, heterogeneous investors, and irrational expectations, are discussed. The main focus is on stock returns and short-term real interest rates, but bond returns are also considered.