Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

# A Quantitative Study of the Role of Wealth Inequality on Asset Prices

Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

# A Quantitative Study of the Role of Wealth Inequality on Asset Prices

## Article excerpt

(ProQuest: ... denotes formulae omitted.)

There is an extensive body of work devoted to understanding the determinants of asset prices. The cornerstone formula behind most of these studies can be summarized in equation (1). The asset pricing equation states in recursive formulation that the current price of an asset equals the present discounted value of future payments delivered by the asset. Namely,

p (s^sub t^) = E [m(s^sub t^, s^sub t+1^) (x (s^sub t+1^) + p (s^sub t+1^)) | s^sub t^], (1)

where p (s) denotes the current price of an asset in state s; x (s) denotes the payments delivered by the asset in state s; and m's, s''denotes the stochastic discount factor from state s today to state s' tomorrow, that is, the function that determines the equivalence between current period dollars in state s and next period dollars in state s'. It is apparent from equation (1) that the stochastic discount factor m plays a key role in explaining asset prices.

One strand of the literature estimatesmusing time series of asset prices, as well as other financial and macroeconomic variables. The estimation procedure is based on some arbitrary functional form linking the discount factor to the explanatory variables. Even though this strategy allows for a high degree of flexibility in order to find the stochastic discount factor that best fits the data, it does not provide a deep understanding of the forces that drive asset prices. In particular, this approach cannot explain what determines the shape of the estimated discount factor. This limitation becomes important once we want to understand how structural changes, like a modification in the tax code, may affect asset prices. The answer to this type of question requires that the stochastic discount factor is derived from the primitives of a model.