Animal spirits in consumption: does confidence influence asset pricing?

Merella, V. and Satchell, Stephen (2007) Animal spirits in consumption: does confidence influence asset pricing? Working Paper. Birkbeck, University of London, London, UK.

Abstract

It is common sense in the financial markets and in the business community to believe that consumer confidence affects consumption growth. The economic literature supports this intuitive causation by presenting strong empirical evidence, though the conceptual foundations of the mechanism triggering this influence have so far been overlooked. This paper offers theoretical grounds to the effect of confidence on growth. We let each commodity marginal utility of consumption vary across the different states of nature. These preference shocks modify the relative willingness to pay among the single industries, thus affecting the demand for each commodity in the market. An index of such demand adjustments arises from optimization, capturing the overall tendency in the individual's attitude towards consumption. Following the mainstream perspective, the index so constructed is interpreted as an indicator of consumer confidence. We apply this setting to an otherwise standard asset pricing framework. A calibration of the resulting model shows that accounting for individual's attitude towards consumption eliminates the equity premium puzzle. We also run a GMM estimation, extending the robustness of our result to the case in which the joint log-normality of consumption, confidence and equity returns is assumed away.

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