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(with Anmol Bhandari and Paul Ho)
Forthcoming in Review of Economic Studies
Previously circulated as NBER WP No. 22225 "Identifying ambiguity shocks in business cycle models using survey data"
This paper develops a theory of subjective beliefs that departs from rational expectations, and shows that biases in household beliefs have quantitatively large effects on macroeconomic aggregates. The departures are formalized using model-consistent notions of pessimism and optimism which are supported by extensive time-series and cross-sectional evidence from household surveys. The role subjective beliefs play in aggregate fluctuations is quantified in a business cycle model with goods and labor market frictions. Consistent with the survey evidence, an increase in pessimism generates upward biases in unemployment and inflation forecasts and lowers economic activity. The underlying belief distortions reduce aggregate demand and propagate through frictional goods and labor markets. As a by-product of the analysis, solution techniques that preserve the effects of time-varying belief distortions in the class of linear solutions are developed.
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The Palgrave Companion to Chicago Economics (2022) Chapter 39, Springer International Publishing, 1005-1055.
Lars Peter Hansen is the David Rockefeller Distinguished Service Professor of Economics at the University of Chicago. His research spans econometrics, macroeconomics, asset pricing, and decision theory and focuses on quantitative implications of decision-making under uncertainty for macroeconomic dynamics, valuation, and economic policy. His contributions to econometrics facilitated formal study of testable implications of economic models, his work on asset pricing laid some of the foundations of a field that is now called macro-finance, while his analysis of ways that econometricians and economic agents cope with uncertainty and potential model misspecification opened new directions for building empirically relevant models in macroeconomics and finance. Hansen received his PhD from the University of Minnesota in 1978, and his wide-ranging contributions were rewarded in 2013 with the Nobel Memorial Prize in Economic Sciences.
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(with John Stachurski)
Journal of Economic Theory (2021) 193: 105227.
We obtain an exact necessary and sufficient condition for the existence and uniqueness of equilibrium asset prices in infinite horizon, discrete-time, arbitrage free environments. Using local spectral radius methods, we connect the condition, and hence the problem of existence and uniqueness of asset prices, with the recent literature on stochastic discount factor decompositions. Our results include a globally convergent method for computing prices whenever they exist. Convergence of this iterative method itself implies both existence and uniqueness of equilibrium asset prices.
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(with John Stachurski)
Journal of Finance (2020) 75 (3): 1457-1493.
We obtain exact necessary and sufficient conditions for existence and uniqueness of solutions of a class of homothetic recursive utility models postulated by Epstein and Zin (1989). The conditions center on a single test value with a natural economic interpretation. The test sheds light on the relationship between valuation of cash flows, impatience, risk adjustment, and intertemporal substitution of consumption. We propose two methods to compute the test value when an analytical solution is not available. We further provide several applications.
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Journal of Political Economy (2020) 128 (1): 206-251.
Circulated under the title Heterogeneous Beliefs under Recursive Preferences.
I study the long-run behavior of an economy with two types of agents who differ in their beliefs and are endowed with homothetic recursive preferences of the Duffie-Epstein-Zin type. Contrary to models with separable preferences in which the wealth of agents with incorrect beliefs vanishes in the long run, recursive preference specifications lead to long-run outcomes where both agents survive, or more incorrect agents dominate. I derive analytical conditions for the existence of nondegenerate long-run equilibria in which agents with differently accurate beliefs coexist in the long run, and show that these equilibria exist for broad ranges of plausible parameterizations when risk aversion is larger than the inverse of the intertemporal elasticity of substitution. The results highlight a crucial interaction between risk sharing, speculative behavior and consumption-saving choice of agents with heterogeneous beliefs, and the role of equilibrium prices in shaping long-run outcomes.
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(with Lars Peter Hansen and José Scheinkman)
Journal of Finance (2016) 71 (6): 2493-2544.
2017 Amundi Smith Breeden Prize Distinguished Paper
Asset prices contain information about the probability distribution of future states and the stochastic discounting of those states as used by investors. To better understand the challenge in distinguishing investors' beliefs from risk-adjusted discounting, we use Perron-Frobenius Theory to isolate a positive martingale component of the stochastic discount factor process. This component recovers a probability measure that absorbs long-term risk adjustments. When the martingale is not degenerate, surmising that this recovered probability captures investors' beliefs distorts inference about risk-return tradeoffs. Stochastic discount factors in many structural models of asset prices have empirically relevant martingale components.
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(with Lars Peter Hansen)
Handbook of Macroeconomics: Volume 2B (2016) Chapter 20, Elsevier B.V., 1641-1696.
Dynamic economic models make predictions about impulse responses that characterize how macroeconomic processes respond to alternative shocks over different horizons. From the perspective of asset pricing, impulse responses quantify the exposure of macroeconomic processes and other cash flows to macroeconomic shocks. Financial markets provide compensations to investors who are exposed to these shocks. Adopting an asset pricing vantage point, we describe and apply methods for computing exposures to macroeconomic shocks and the implied compensations represented as elasticities over alternative payoff horizons. The outcome is a term structure of macroeconomic uncertainty.
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(with Lars Peter Hansen and José Scheinkman)
Mathematics and Financial Economics (2014) 8 (4): 333-354.
We construct shock elasticities that are pricing counterparts to impulse response functions. Recall that impulse response functions measure the importance of next-period shocks for future values of a time series. Shock elasticities measure the contributions to the price and to the expected future cash flow from changes in the exposure to a shock in the next period. They are elasticities because their measurements compute proportionate changes. We show a particularly close link between these objects in environments with Brownian information structures.
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(with Lars Peter Hansen)
Journal of Econometrics (2014) 183 (1): 67-90.
We develop new methods for representing the asset-pricing implications of stochastic general equilibrium models. We provide asset-pricing counterparts to impulse response functions and the resulting dynamic value decompositions (DVDs). These methods quantify the exposures of macroeconomic cash flows to shocks over alternative investment horizons and the corresponding prices or investors' compensations. We extend the continuous-time methods developed in Hansen and Scheinkman (2012) and Borovička, Hansen, Hendricks, and Scheinkman (2011) by constructing discrete-time, state-dependent, shock-exposure and shock-price elasticities as functions of the investment horizon.
Our methods are applicable to economic models that are nonlinear, including models with stochastic volatility.
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(with Lars Peter Hansen, Mark Hendricks, and José Scheinkman)
Journal of Financial Econometrics (2011) 9 (1): 3-65.
We present a novel approach to depicting asset pricing dynamics by characterizing shock exposures and prices for alternative investment horizons. We quantify the shock exposures in terms of elasticities that measure the impact of a current shock on future
cash-flow growth. The elasticities are designed to accommodate nonlinearities in the stochastic evolution modeled as a Markov process. Stochastic growth in the underlying macroeconomy and stochastic discounting in the representation of asset values are central ingredients in our
investigation. We provide elasticity calculations in a series of examples featuring consumption externalities, recursive utility, and jump risk.