Substitution, Risk Aversion, and the Temporal Behavior of Consumption and Asset Returns: An Empirical Analysis

This paper investigates the testable restriction on the time-series behavior of consumption and asset returns implied by a representative agent model in which intertemporal preferences are represented by utility functions that generalize conventional, time-additive, expected utility. The model based on these preferences allows a clearer separation of observable behavior attributable to risk aversion and to intertemporal substitution. Further, it nests the predictions of both the consumption CAPM and the static CAPM, and it allows direct tests of the expected utility hypothesis. We find that the performance of the non-expected utility model and tests of the expected utility hypothesis are sensitive to the choice of both consumption measure and instrumental variables.