Intertemporal Substitution and Equity Premium: A Perspective with Habit in Epstein-Zin Preferences

Abstract

This paper presents a consumption based model that reveals intertemporal substitution as a distinctive and important channel, separate from risk aversion, in generating equity premium, return volatility, and their cyclical variations. Two main ingredients, Epstein-Zin preferences and external habit, allow the model to distinguish the separate effects of intertemporal substitution and risk aversion. The results indicate an effective elasticity of intertemporal substitution that is much lower than the parameter value and varies procyclically. On the other hand, the effective risk aversion is counter-cyclical and much higher than the parameter value. To match the empirical statistics of the post-war U.S. stock market, the model critically requires a small elasticity parameter below 1. This points to an interesting contrast between the habit formation and the long-run consumption risk models.