Experiments With The Lucas Asset Pricing Model

For over thirty years, the model of Lucas (1978) has been the platform of research on dynamic asset pricing and business cycles. This model restricts the intertemporal behavior of asset prices and ties those restrictions to cross-sectional behavior (the “equity premium”). The intertemporal restrictions reject the strictest interpretation of the Efficient Markets Hypothesis, namely, that prices should follow a martingale. Instead, prices move with economic fundamentals, and to the extent that these fundamentals are predictable, prices should be too. The Lucas model also prescribes the investment choices that facilitate smoothing of consumption over time. Here, we report results from experiments designed to test the primitives of the model. Our design overcomes, in novel ways, challenges to generate demand for consumption smoothing in the lab, and to induce stationarity in spite of the finite duration of lab experiments. The experiments provide overall support for the price and allocation predictions of the model, although the intertemporal price predictability is too small given observed cross-sectional price differences. Investment choices are, in turn, consistent with the low level of price predictability.1 ∗University of Utah †Caltech and SFI at EPFL ‡Caltech §UCLA Financial support from Inquire Europe, the Hacker Chair at the California Institute of Technology (Caltech), and the Development Fund of the David Eccles School of Business at the University of Utah is gratefully acknowledged.