Habit Formation Heterogeneity: Implications for Aggregate Asset Pricing

Abstract

We explicitly solve for the aggregate asset pricing quantities of a general equilibrium Lucas endowment economy inhabited by two agents with habit formation preferences. Preferences are modeled either as internal or external habits. We allow for agents' heterogeneity in relative risk aversion and habit strength. Equilibrium quantities, such as equity premium, equity volatility, Sharpe ratio, interest rate volatility, and asset holdings are computed using a recently developed algorithm of Dumas and Lyasoff (2011). The algorithm is refined to capture time-nonseparability induced by habit. We obtain that internal habits provide for a considerable improvement in obtaining aggregate asset pricing quantities consistent with historically observed magnitudes as opposed to 'catching up with Joneses' preferences.