Management Science , Vol. 69, Issue 5, pp. 2972 - 3002, 2023

Extreme Inflation and Time-Varying Expected Consumption Growth

In a parsimonious regime switching model, wefind strong evidence thatexpected consumption growth varies over time. Adding inflation as a second variable, weuncover two states in which expected consumption growth is low, one with high and onewith negative expected inflation. Embedded in a general equilibrium asset pricing modelwith learning, these dynamics replicate the observed time variation in stock return volatil-ities and stock-bond return correlations. They also provide an alternative derivation for ameasure of time-varying disaster risk suggested by Watcher [Wachter J (2013) Can time-varying risk of rare disasters explain aggregate stock market volatility?J. Finance68(3):987–1035]. implying that both the disaster and the long-run risk paradigm can beextended toward explaining movements in the stock-bond correlation.