Knowledge that Transforms

Deaton's observation that consumption appears to be “too smooth” is easily reconciled with the notion that consumption exhibits “excess sensitivity” to current income. The reconciliation invokes the plausible assumption that households forecast on the basis of a larger information set than the econometrician. The empirical case for excess smoothness is strengthened by showing that the innovations in permanent income can be inferred from an autoregression of income and saving, not only under the permanent income hypothesis, but also under the excess sensitivity model. Empirically, parameter restrictions imposed on the bivariate autoregression by the excess sensitivity model are not rejected.

This paper estimates an equilibrium model of stock price behaviour in which changes in exponentially de-trended dividends and prices are normally distributed and exogenous “noise traders” interact with “smart-money” investors who have constant absolute risk aversion. The model can explain the volatility and predictability of U.S. stock returns in the period 1871–1986 using either a low discount rate (4% or below) and a large constant risk discount on the stock price, or a higher discount rate (5% or above) and noise trading correlated with fundamentals. The data are not well able to distinguish between these explanations.

This paper presents a dynamic asset-pricing model under asymmetric information. Investors have different information concerning the future growth rate of dividends. They rationally extract information from prices as well as dividends and maximize their expected utility. The model has a closed-form solution to the rational expectations equilibrium. We find that existence of uninformed investors increases the risk premium. Supply shocks can affect the risk premium only under asymmetric information. Information asymmetry among investors can increase price volatility and negative autocorrelation in returns. Less-informed investors may rztionally behave like price chasers.