[We show that bond risk premia rise with uncertainty about expected inflation and fall with uncertainty about expected growth; the magnitude of return predictability using these uncertainty measures is similar to that by multiple yields. Motivated by this evidence, we develop and estimate a long-run risks model with timevarying volatilities of expected growth and inflation. The model simultaneously accounts for bond return predictability and violations of uncovered interest parity in currency markets. We find that preference for early resolution of uncertainty, time-varying volatilities, and non-neutral effects of inflation on growth are important to account for these aspects of asset markets.]

[We develop a general equilibrium model in which income and dividends are smooth but asset prices contain large moves (jumps). These large price jumps are triggered by optimal decisions of investors to learn the unobserved state. We show that learning choice is determined by preference parameters and the conditional volatility of income process. An important model prediction is that income volatility predicts future jump periods, while income growth does not. Consistent with the model, large moves in returns in the data are predicted by consumption volatility but not by consumption growth. The model quantitatively captures these novel features of the data.]

High expected inflation is known to predict low future real growth. We show that, relative to nondurable goods sectors of the economy, such predictability is significantly more pronounced in durable sectors. Consistent with this macroeconomic evidence, the equity returns of durable goods-producing firms have a larger negative exposure to expected inflation risks. We estimate a two-good recursive utility model that features persistent growth fluctuations and inflation nonneutrality for durable and nondurable consumption. Our model can quantitatively account for the levels and volatilities of bond and equity prices, and correlations of equity returns with bond returns and with expected inflation.

Measures of US government policy approval are strongly related to persistent fluctuations in the dollar value. Contemporaneous correlations between approval ratings and the dollar approach 50% against advanced economy currencies. High approval ratings further forecast a decline in the dollar risk premium several years ahead and are associated with a persistent increase in economic growth and a reduction in economic volatility. We provide an illustrative model to interpret our empirical evidence. In the model, policy valuations (approvals) are forward-looking and increase at times of high expected policy-related growth and low policy-related uncertainty, which are times of a strong dollar and low dollar risk premium.

We find that high productivity-based macroeconomic uncertainty is associated with greater accumulation of physical capital despite a reduction in investment and valuations. To reconcile this puzzling evidence, we show that uncertainty predicts lower aggregate depreciation of existing capital, which dominates the investment slowdown. We explain these findings by developing a quantitative production-based model in which firms implement precautionary savings through reducing utilization rather than raising investment. Through this novel intensive-margin mechanism, uncertainty shocks command a quarter of the equity premium in general equilibrium. Flexibility in utilization adjustments also helps explain uncertainty risk exposures in the cross-section of industry returns.

We show that bond risk premia rise with uncertainty about expected inflation and fall with uncertainty about expected growth; the magnitude of return predictability using these uncertainty measures is similar to that by multiple yields. Motivated by this evidence, we develop and estimate a long-run risks model with timevarying volatilities of expected growth and inflation. The model simultaneously accounts for bond return predictability and violations of uncovered interest parity in currency markets. We find that preference for early resolution of uncertainty, time-varying volatilities, and non-neutral effects of inflation on growth are important to account for these aspects of asset markets.

We develop a general equilibrium model in which income and dividends are smooth but asset prices contain large moves (jumps). These large price jumps are triggered by optimal decisions of investors to learn the unobserved state. We show that learning choice is determined by preference parameters and the conditional volatility of income process. An important model prediction is that income volatility predicts future jump periods, while income growth does not. Consistent with the model, large moves in returns in the data are predicted by consumption volatility but not by consumption growth. The model quantitatively captures these novel features of the data.

Does macroeconomic uncertainty increase or decrease aggregate growth and asset prices? To address this question, we decompose aggregate uncertainty into ‘good’ and ‘bad’ volatility components, associated with positive and negative innovations to macroeconomic growth. We document that in line with our theoretical framework, these two uncertainties have opposite impact on aggregate growth and asset prices. Good uncertainty predicts an increase in future economic activity, such as consumption, output, and investment, and is positively related to valuation ratios, while bad uncertainty forecasts a decline in economic growth and depresses asset prices. Further, the market price of risk and equity beta of good uncertainty are positive, while negative for bad uncertainty. Hence, both uncertainty risks contribute positively to risk premia, and help explain the cross-section of expected returns beyond cash flow risk.

Asset price movements in many cases seem de-linked from aggregate economic fundamentals. Forexample, RaviBansal andIvanShaliastovich (2008a) show that frequent large moves in asset prices, i.e. jumps, on average are not correlated with movements in macro-variables (see Table 1 below). Motivated by this, we present a general equilibrium model in which variation in investor confidence about expected growth determines risk premia and hence asset prices. This confidence risk channel can account for (i) the lack of connection between large asset-price moves and macro-variables such as consumption, (ii)large declinesinassetprices, thatis, the left tail of the return distribution, and (iii) observed predictability of equity returns and consumption growth by the price to dividend ratio. In essence, we present a model in which behaviorally motivated shifts in expectations play an important role for the asset prices. Our economy set-up follows a standard longrun risks specification of Ravi Bansal and Amir Yaron (2004), and features Gaussian consumption growth process with time-varying expected growth and volatility; there are no large moves orjumpsintheunderlyingconsumptionanddividenddynamics. Expectedgrowth isnotdirectly observable, and investors learn about it using the cross-section of signals. The time-varying cross-sectional varianceof thesignals determines the quality of the information, and therefore the confidence that investors place in their growth forecast. In the long-run risks framework, the fluctuations in confidence risk determines risk premia and asset prices. We model investors as being recency-biased in their expectation formation, that is, they overweigh recent observations as in Werner De Bondt and Richard Thaler (1990). This is important, as in the standard Kalman-Filter based expectation formation, periods of low information quality get down-weighted, which diminishes the role of the confidence risk channel.

High expected inflation is known to predict low future real growth. We show that, relative to nondurable goods sectors of the economy, such predictability is significantly more pronounced in durable sectors. Consistent with this macroeconomic evidence, the equity returns of durable goods-producing firms have a larger negative exposure to expected inflation risks. We estimate a two-good recursive utility model that features persistent growth fluctuations and inflation nonneutrality for durable and nondurable consumption. Our model can quantitatively account for the levels and volatilities of bond and equity prices, and correlations of equity returns with bond returns and with expected inflation.