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Economic Quarterly

Third Quarter 2014

How Can Consumption-Based Asset-Pricing Models Explain Low Interest Rates?

Felipe F. Schwartzman

The real interest rate is at historically low levels following the Great Recession. This article examines under which conditions the leading consumption-based asset-pricing models can give rise to such a reduction. In particular, we examine implications of standard constant relative risk aversion preference models with Gaussian shocks, models with consumption disaster, models with long-run risk, and models with habit formation. Given the models reviewed, the high-risk premium suggests that low interest rates in the recent period are likely to be either a consequence of a perception that consumption risk is particularly high, or of very low risk tolerance.

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