Date of Degree

5-2018

Document Type

Dissertation

Degree Name

Ph.D.

Program

Economics

Advisor

Christos Giannikos

Committee Members

Sebastiano Manzan

Merih Uctum

Subject Categories

Economic Theory | Finance | Income Distribution

Keywords

wealth inequality, equity risk premium, durable good, habit formation, background risk

Abstract

Economic and financial theories are often found to be in conflict with empirical evidence, suggesting revisions and elaborations of existing models. There are usually many revisions proposed in response to these "puzzles", but often the true resolution may be a factor not yet realized. This dissertation consists of three chapters and contributes to the explanation of a persistent and significant anomaly, the equity premium puzzle, by taking into account the implications of wealth inequality on consumer preferences and, consequently, on asset prices.

The first chapter examines how wealth inequality affects asset prices in a complete market setting. Wealth inequality is introduced through a mean preserving transfer of endowment. This creates the departure from an egalitarian distribution of wealth. It seems that wealth inequality is important to explain fluctuations in asset prices, as long as durability of the good and habit forming preferences of agents are considered.

The second chapter studies the relationship between wealth inequality and asset pricing in both complete and incomplete markets. To this end, we examine how wealth inequality affects the equilibrium level of the return on equity, the risk free rate and, consequently, the equity premium, in an exchange economy with identical agents, except for their initial endowment. The novelty of our approach is that (i) we incorporate a single durable good and habit forming preferences of agents and (ii) calibrate our model with updated data on wealth inequality. For our calibrations we introduce two equally weighted classes and three unequally weighted classes of wealth. We also explore the effects of the addition of an non-hedgeable labor income risk, which creates an element of market incompleteness to our model. The following results are documented: In complete markets, and under certain conditions, wealth inequality can drive the equity premium up to its historically observed levels, when there is a single durable good or the agents exhibit internal habit persistence with substitutability of consumption. In incomplete markets, the presence of a larger background risk is required to drive the equity premium down, when good is durable or when agents exhibit internal habit persistence and a lower level of background risk is required when agents have external habits.

The third chapter investigates the implications of wealth inequality on prices of durable assets in an economy with Epstein Zin preferences of agents. Wealth inequality does not affect asset prices in fully insurable markets but has an important effect in incomplete markets. When agents have a stronger preference for resolution of uncertainty, durability decreases the equity premium, while, for agents with a weaker preference for resolution of uncertainty, a durable good increases the equity premium. Furthermore, departing from an egalitarian economy can even cause a reduction of the equity risk premium. Questions are raised about the level of background risk, required to decrease the equity premium in the unequal economy.

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