Abstract
Campbell and Cochrane (1999) formulate a model that successfully explains a wide variety of asset pricing puzzles, by augmenting the standard power utility function with a time-varying “external habit”, that adapts nonlinearly to current and past average consumption in the economy. We demonstrate that their preference specification has the unusual implications that habit can move negatively with consumption, and that the social marginal utility can be negative. As a result, government interventions that occasionally destroy part of the endowment can lead to substantial welfare improvements. JEL code: E21, E44, G12 Ljungqvist: Stockholm School of Economics and New York University (email: lars.ljungqvist@hhs.se); Uhlig: University of Chicago (email: huhlig@uchicago.edu). We thank Fernando Alvarez and John Cochrane for criticisms and suggestions on our earlier exploration of the properties of the Campbell-Cochrane preference specification. The present exposition has benefitted much from the comments of the editor and three anonymous referees. Ljungqvist’s research was supported by a grant from the Jan Wallander and Tom Hedelius Foundation. Uhlig’s research has been supported by the NSF grant SES-0922550.
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