Buffer Stock Saving and Habit Formation

Abstract

This paper investigates whether an infinite horizons buffer stock saving model with internal, multiplicative, habit formation preferences can replicate the macroeconomic stylized facts about consumption expenditures on non-durables and services. Individual consumption smoothing and consumption sensitivity to lagged earnings induced by habit formation survive the numerical aggregation procedure replicating in magnitude the observed smoothness of aggregate non-durables consumption growth and the sensitivity of current consumption growth to lagged labor income growth. Nevertheless, this empirical success is associated with substantial wealth accumulation. To the extent, therefore, that the buffer stock model without habits adequately replicates the wealth accumulation profile of the median consumer, the proposed modification cannot jointly explain in magnitude the smoothness of consumption and its excess sensitivity to lagged labor income.