ABSTRACT
Introduction and motivation In this chapter, an agent-based computational capital asset pricing model is applied to address the issue, known as the elasticity puzzle, originating from a famous reciprocal relation between the elasticity of intertemporal substitution and the relative risk aversion coefficient. Based on this reciprocal relation, the implied relative risk aversion coefficient can be unexpectedly, and possibly unacceptably, high when the estimated elasticity of intertemporal substitution is very low and even close to zero. Existing studies on the elasticity puzzle, be they theoretical or empirical, are largely confined to the conventional framework built upon the devices of rational expectations and representative agents. A number of recent empirical studies, however, have documented that agents are heterogeneous in their elasticity of intertemporal substitution.1 Two questions immediately arise. The first one concerns the aggregation problem. If the intertemporal elasticity is heterogeneous among agents, then what is the relation between the aggregate elasticity and its individual counterparts? This leads us to the very basic issue raised by Alan Kirman (1992), ‘whom or what does the representative individual represent?’ The second one is to do with why the rich and the stockholders tend to have to high intertemporal elasticities, and their counterparts tend to have low ones. Why is such a behavioural parameter so critical in determining the wealth share of individuals?2 Empirical studies also find that the Euler consumption equation applies well only to the stock market participants, and not to all individuals. It is certainly plausible that not all individuals can be good at optimizing. So, here comes the third question. Is it possible for some agents who happen to be good at optimizing and hence behave closer to what the Euler equation predicts to eventually become wealthier, and for those who do not and hence fail to meet the Euler equation to eventually become poor? Do the rich really have different intertemporal elasticities as opposed to their opposites, or are they just ‘smarter’ or endowed with better luck? Is it possible for the ‘observed’ heterogeneity in intertemporal elasticity to be just spurious? In sum, what is the relationship between the observable elasticity and the true one, considering that agents are boundedly rational?
