Consumption and asset prices

• Date: 25 January 2002
• Author: Raymond P Neveu,H.J Smoluk
• Published date: 25 January 2002
• DOI: http://doi.org/10.1016/S1058-3300(02)00037-X

Consumption and asset prices

An analysis across income groups

H.J. Smoluk*, Raymond P. Neveu

School of Business, University of Southern Maine, 96 Falmouth Street, PO Box 9300,

Portland, ME 04104-9300, USA

Received 29 May 2000; received in revised form 5 November 2000; accepted 12 December 2001

Abstract

Employing aggregate consumption data to test the consumption-based capital asset pricing model

(CCAPM) is likely to lead to a specification error since a significant portion of consumers live from

paycheck-to-paycheck and, therefore, are constrained in their ability to intertemporally allocate

consumption. Furthermore, these consumers lack the savings needed to directly influence an

equilibrium between consumption expenditures and asset returns. Using consumption expenditures

grouped by consumer income, this paper examines the issue of whether the CCAPM is more consistent

with the consumption of unconstrained (high-income) consumers as compared to constrained (low-

income) consumers. Several traditional methods of analyzing the CCAPM are explored utilizing five

time series of consumption expenditures delineated by consumer income. This approach allows us to

indirectly test whether liquidity constraints affect the CCAPM without imposing additional specification

on the model. Overall, the tests fail to find any discernible patterns across income groups that are

consistent with the idea that liquidity constraints bind lower income consumers. D2002 Elsevier

Science Inc. All rights reserved.

1. Introduction

The theoretical models that bridge microeconomics and finance have been the subject of

numerous empirical studies which, for the most part, find an inconsistent relationship

1058-3300/02/$ – see front matter D2002 Elsevier Science Inc. All rights reserved.

PII: S1 058-3300(02)00 037-X

* Corresponding author. Tel.: +1-207-780-4407; fax: +1-207-780-4662.

E-mail address: hsmoluk@usm.maine.edu (H.J. Smoluk).

Review of Financial Economics 11 (2002) 47– 62

between US consumption data and asset returns.

1

The inconsistency stems from the finding

that equity risk, as measured by the covariance between stock returns and consumption

growth within the context of the consumption-based capital asset pricing model (CCAPM),

is too small to warrant the large average risk premium on stocks. In other words, the

CCAPM shows that aggregate investors, or the representative single agent, must be

extremely averse to consumption risk (corresponding to a large coefficient of relative risk

aversion) to demand such a large equity premium. The disparity between the predictions of

these models and the data are so pronounced that the literature has continued to refer to this

phenomenon as the ‘‘equity premium puzzle,’’ based on the work of Mehra and Prescott

(1985), who first brought the issue to light.

Attempts to rescue the CCAPM or solve the equity premium puzzle are bountiful. They

seek to unravel the assumptions employed by Mehra and Prescott (1985) in hopes of ex-

plaining this puzzle. The assumptions, as well as the literature attacking these assumptions,

are typically categorized into three (not necessarily mutual exclusive) areas: consumer

preferences, the representative agent, and market frictions. In brief, papers focusing on the

consumer preference assumption seek to generalize the very convenient time-separable power

utility function employed by Mehra and Prescott. Papers focusing on the representative agent

assumption examine the implications of using aggregate consumption data to test the

CCAPM. And finally, papers studying market frictions examine transaction costs, the im-

plication of incomplete markets, and economically constrained consumers.

The purpose of this paper is to examine the implications of economically constrained and

unconstrained consumers on the standard CCAPM. It therefore spans the area of surrounding

the representative agent assumption, as well as, market frictions (see Campbell, Lo, &

MacKinlay, 1997, p. 317 for an in-depth review of these issues). More specifically, this

paper seeks to determine whether real asset returns are more consistent with the consumption

patterns of higher income consumers than lower income consumers. The hypothesis is that

the consumption patterns of lower income consumers, who live from paycheck-to-paycheck,

should bear a weaker relation to real asset returns than higher income consumers since they

lack the ability to save and manipulate consumption. This hypothesis suggests that

traditional tests of the CCAPM based on national per capita consumption are misspecified

since a significant portion of consumers either do not save or have negligible savings rates.

Furthermore, even if these consumers have some savings, their awkward economic position

would indicate that they probably do not manipulate their consumption patterns based on

expected real asset returns. An important element of the tests employed in this paper is that

they do not impose any form of liquidity constraint on the CCAPM, thus eliminating the

possibility of additional misspecification.

The paper is organized as follows. Section 2 reviews the CCAPM literature and its

relation to the equity premium puzzle of Mehra and Prescott (1985). Section 3 covers the

1

For theoretical models, see Breeden (1979, 1986), Lucas (1978), and Rubenstein (1976). For the empirical

studies, see Grossman and Shiller (1981), Kocherlakota (1996), and Mehra and Prescott (1985) for an in-depth

literature review. Our discussion follows Campbell et al. (1997).

H.J. Smoluk, R.P. Neveu / Review of Financial Economics 11 (2002) 47–6248