A prior predictive analysis of the effects of Loss Aversion/Narrow Framing in a macroeconomic model for asset pricing

In a macroeconomic framework, I quantitatively evaluate the theory of Loss Aversion/Narrow Framing (LANF) as a resolution to the Equity Premium Puzzle (EPP). The EPP is where the neoclassical asset pricing model cannot be reconciled with the empirical fact that stocks have much higher returns than risk-free assets. The prior predictive analysis employed follows a Bayesian approach that draws realizations for preferences that describe the degree of LANF characterizing consumer’s tastes. The analysis is also extended along two more dimensions: the variance of aggregate uncertainty and the elasticity of labor. The priors used are carefully defined from previous works in the literature. This Monte Carlo procedure finds that the theory is unable to jointly describe the equity premium and labor’s elasticity of supply. That is, only when the labor supply elasticity is unreasonably low can LANF preferences generate any equity premiums. Alternatively, when the elasticity is more realistically high, LANF preferences fail to generate significant premiums. My analysis therefore concludes that a resolution to the EPP via a theory of LANF must be modified along the description of labor’s choices. As ancillary result, the hybrid perturbation-projection method developed for this experiment is shown to be a robust technique.