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Campbell and Cochrane meet Melino and Yang: Reverse engineering the surplus ratio in a Mehra–Prescott economy

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  • Dolmas, Jim

Abstract

The well-known habit model of Campbell and Cochrane (1999) specifies a process for the ‘surplus ratio’—the excess of consumption over habit, relative to consumption—rather than an evolution for the habit stock. This paper shows that Campbell–Cochrane preferences can be accommodated in a Markov chain framework à la Mehra and Prescott (1985) and mapped into an equivalent state-dependent form of the sort studied by Melino and Yang (2003). The equivalence sheds light on the workings of Campbell–Cochrane preferences and the plausibility of upcounting in Melino and Yang’s framework. The result may also have some pedagogical value.

Suggested Citation

  • Dolmas, Jim, 2017. "Campbell and Cochrane meet Melino and Yang: Reverse engineering the surplus ratio in a Mehra–Prescott economy," The North American Journal of Economics and Finance, Elsevier, vol. 40(C), pages 55-62.
    • Handle: RePEc:eee:ecofin:v:40:y:2017:i:c:p:55-62
    DOI: 10.1016/j.najef.2017.01.006
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    References listed on IDEAS

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    1. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
    2. Bryan R. Routledge & Stanley E. Zin, 2010. "Generalized Disappointment Aversion and Asset Prices," Journal of Finance, American Finance Association, vol. 65(4), pages 1303-1332, August.
    3. John Y. Campbell & John Cochrane, 1999. "Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior," Journal of Political Economy, University of Chicago Press, vol. 107(2), pages 205-251, April.
    4. Angelo Melino & Alan X. Yang, 2003. "State Dependent Preferences Can Explain the Equity Premium Puzzle," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 6(4), pages 806-830, October.
    5. Campbell, John Y. & Yogo, Motohiro, 2006. "Efficient tests of stock return predictability," Journal of Financial Economics, Elsevier, vol. 81(1), pages 27-60, July.
    6. Francisco Azeredo, 2014. "The equity premium: a deeper puzzle," Annals of Finance, Springer, vol. 10(3), pages 347-373, August.
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    More about this item

    Keywords

    Habit; Asset returns; Stochastic discount factor; State-dependent preferences;
    All these keywords.

    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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