Can Costs of Consumption Adjustment Explain Asset Pricing Puzzles?

Abstract

We investigate Grossman and Laroque's (1990) conjecture that costs of adjusting consumption can account, in part, for the empirical failure of the consumption‐based capital asset pricing model (CCAPM). We incorporate small fixed costs of consumption adjustment into a CCAPM with heterogeneous agents. We find that undetectably small consumption adjustment costs can account for much of the discrepancy between the observed variance of nondurable aggregate consumption growth and the predictions of the CCAPM, and can partially reconcile nondurable consumption data with the observed equity premium. We conclude that the CCAPM's implications are nonrobust to extremely small adjustment costs.

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