The effects of risk aversion and money illusion on the components of dividend growth rate

We evaluate the impact of risk aversion and money illusion in the equity and options markets when the expected dividend growth rate is endogenously determined as a function of the dividend-price ratio and expected inflation. The closed-form equilibrium expressions for the dividend-price ratio, expected inflation, and dividend growth rate allow us to perform comparative statics to understand their sensitivity relative to the agent’s preference parameters. Our calibration exercise indicates that the sensitivity of the dividend-price ratio relative to risk aversion depends critically on the sign of the exposure of the expected dividend growth rate to the divided yield, while an increase in the degree of money illusion always raises the dividend-price ratio, irrespective of its exposure to the dividend yield. In addition, we show that expected inflation is much less sensitive to variations in risk aversion and money illusion than these parameters, while the price of a zero-coupon caplet is affected in the opposite direction by these parameters.