Wealth Inequality and Asset Pricing

In an Arrow–Debreu exchange economy with identical agents except for their initial endowment, we examine how wealth inequality affects the equilibrium level of the equity premium and the risk-free rate. We first show that wealth inequality raises the equity premium if and only if the inverse of absolute risk aversion is concave in wealth. We then show that the equilibrium risk-free rate is reduced by wealth inequality if the inverse of the coefficient of absolute prudence is concave. We also prove that the combination of a small uninsurable background risk with wealth inequality biases asset pricing towards a larger equity premium and a smaller risk-free rate.