The Impact of Idiosyncratic Shocks on Welfare and Asset Returns in a Stochastically Growing Economy

Stochastic models with economy-wide shocks imply that the welfare costs of aggregate volatility are negligible and contribute little to explaining the equity premium puzzle. Motivated by this failure, this paper introduces idiosyncratic shocks. Drawing on empirical evidence suggesting that the volatility of such shocks is several times that of aggregate shocks, we find that for plausible degrees of risk aversion, the welfare costs of risk are around 2-4%, while idiosyncratic risk may account for about one percentage point of the observed equity premium. Both effects increase sharply with the degree of risk aversion and the magnitude of the idiosyncratic shocks. For high, but plausible, degrees of risk aversion and idiosyncratic shocks the model may account for virtually all the observed equity premium, though with excessively high welfare costs. The paper emphasizes the tradeoffs involved in analyzing the effects of risk on growth, welfare and asset pricing, clarifying the need to examine these issues within a unified stochastic general equilibrium framework.