The relationship between aggregate consumption, productivity of capital, and levels of stock and bond market prices is a fundamental issue in macroeconomics and finance. From a macroeconomic policy perspective, an adequate understanding of the interactions between real market activities and financial market changes is necessary for formulating policies with direct impact on the financial markets. In addition, a reasonable theory of the relationship between savings/consumption and changes in levels of prices of financial assets can help policy makers interpret the signals that the financial markets continuously send about the future course of economic activities. The contribution of this project comes in developing a new theory for the study of financial asset prices that provides a more realistic representation of intertemporal consumption preferences than the classical additive utility model. This project studies the microeconomic implications of a model of choice under uncertainty in continuous time. The agents in this model treat consumption at nearby dates as almost perfect substitutes except possibly at information surprises. All the time-additive as well as almost all the non-time additive utility functions used in the literature fail to satisfy this local substitution property. The project also investigates models of habit formation while retaining the local substitutability of consumption.
