Long-Run Risk through Consumption Smoothing

Abstract

We examine how long-run consumption risk arises endogenously in a standard production economy model where the representative agent has Epstein–Zin preferences. We show that even when technology growth is i.i.d., optimal consumption smoothing induces long-run risk—highly persistent variation in expected consumption growth. As a consequence, the model can account for a high price of risk, although both consumption growth volatility and the coefficient of relative risk aversion are low. The asset pricing implications of endogenous long-run risk depend crucially on the persistence of technology shocks and investors’ preference for the timing of resolution of uncertainty. ( JEL E21, E23, E30, G12)