Epstein–Zin Utility, Asset Prices, and the Business Cycle Revisited

Abstract This paper discusses the advantages of Epstein and Zin (1989) (EZ) preferences when building dynamic stochastic general equilibrium (DSGE) models that are consistent with well-known stylized facts of both the business cycle and asset markets. To this end, we combine EZ preferences with several building blocks from the DSGE literature that has tried to solve the equity premium puzzle and to replicate characteristic statistics of the labor market. Our goal is to guide researchers in this area to useful modeling devices and to discuss EZ preferences vis-a-vis the standard time-additive expected utility function. EZ preferences separate the attitude toward risk from the attitude toward intertemporal substitution. We demonstrate that this additional degree of freedom allows us to closely match the empirical facts already in a frictionless production economy with endogenous labor supply. Our study follows Heer and Maußner (2013). We examine models that consider adjustment costs of capital accumulation, consumption habits, and frictions in the allocation of labor. Our empirical targets are estimated from German data.