External Habits Research Articles

Relative Consumption: The Strength of Internal and External Habits

This paper investigates the presence and strength of internal and external habit formation in consumption, using monthly household data. The habit hypothesis is used to explain empirical regularities in macroeconomics and finance. Empirical studies based on aggregate data (macro-evidence) leave the micro-behavior unexplored. The micro-evidence is inconclusive and primarily based on food consumption data. Unfortunately, food consumption is a bad proxy for total consumption — mainly, because food consumption preferences differ considerably from consumption preferences of other goods (Shea (1994)). Thus, I use total household consumption data to test the Euler equations of an additive habit formation model. There is evidence for internal and external habits; the external habit effect is about three times larger than the internal effect. Extensions to alternative habit coefficients are provided.

Lifecycle consumption plans, social learning and external habits: Experimental evidence

We report results from a laboratory experiment exploring the extent to which individuals can solve a deterministic, intertemporal lifecycle consumption optimization problem and the effect of revealing social information on past average consumption amounts; as all individuals have identical induced preferences and lifetime incomes, such social information could be useful in solving for the optimal consumption path. Instead, we find that the provision of social information on past average levels of consumption results in a greater deviation of consumption from both the unconditional and the conditionally optimal paths. We find some improvement in consumption planning relative to the conditional optimum when social concerns (external habits) are explicitly incorporated into subject's period utility functions as in external habit formation preference specifications. Our results on the effects of social information on consumption behavior may help to explain the phenomenon of over-consumption and under-saving that has been observed in many developed countries in recent decades as social information on the behavior of others has become more readily available.

Equilibrium dynamics in a class of one-sector endogenous growth models with external habits: An application of special functions

This paper analyzes the equilibrium dynamics in a class of one-sector endogenous growth models with external habits. Using an explicit solution expressed in terms of the Gauss hypergeometric function, we show that the levels of consumption, habits and capital may exhibit non-monotonic transition dynamics, even though their ratios converge monotonically. A numerical simulation illustrates this result.

Local and global bifurcations in an economic growth model with endogenous labour supply and multiplicative external habits

This paper analyses the mathematical properties of an economic growth model with overlapping generations, endogenous labour supply, and multiplicative external habits. The dynamics of the economy is characterised by a two-dimensional map describing the time evolution of capital and labour supply. We show that if the relative importance of external habits in the utility function is sufficiently high, multiple (determinate or indeterminate) fixed points and poverty traps can exist. In addition, periodic or quasiperiodic behaviour and/or coexistence of attractors may occur.

Evaluating monetary policy under preferences with zero wealth effect: A Bayesian approach

Both real and monetary macro models have parallely exploited the potential for various preferences in accounting for empirical facts. This paper brings the two literatures together by estimating time non-separable preferences with habit formation in consumption that nests several commonly used preferences. In the absence of wealth effects and external habits, these preferences fail to generate observed inflation inertia and output persistence after a monetary policy shock. Furthermore, the data strongly rejects these preferences in favor of preferences with external habits. An alternative solution is to include habit adjusted intermediate wealth effect preferences which are able to simultaneously generate sluggish responses of the variables to a monetary policy shock and fit the data better.

The New Keynesian Approach to Monetary Policy Analysis and Consumption: Case Study (OPEC Countries)

While consumption habits have been utilized as a means of generating a hump shaped output response to monetary policy shocks in sticky-price New Keynesian economies, there is relatively little analysis of the impact of habits (particularly, external habit s) on optimal policy. In this paper we consider the implications of external habits for optimal monetary policy, when those habi ts either exist at the level of the aggregate basket of consumption goods or at the level of individual goods. External habits g enerate an additional distortion in the economy, which implies that the flex-price equilibrium will no longer be efficient and that policy faces interesting new trade-offs and potential stabilization biases. Furthermore, the endogenous mark-up behavior, which emerges when habits are deep, can also significantly affect the optimal policy response to shocks, as well as dramatically affecting the stabilizing properties of standard simple rules. I discuss several lessons regarding the design and conduct of monetary policy that have emerged out of the New Keynesian research program. Those lessons include the benefits of price stability, the gains from commitment about future policies, the importance of natural variables as benchmarks for policy, and the benefits of a credible anti-inflationary stance.

Testing External Habits in an Asset Pricing Model

The asset pricing model with external habit formation predicts that the equity premium depends on consumption changes relative to the habit level, implying a response that varies over the business cycle. We test this implication using a VAR model of the U.S. postwar economy whose time-varying parameters are estimated conditioning on Markov-switching regimes that shift according to the business cycle phases. This enables us to test whether the non-linear response predicted in the model is significant. The results show that the response of the equity premium to consumption shocks is insignificantly different over the business cycle. We interpret this as evidence against the external habit formation hypothesis.

Optimal monetary policy in a New Keynesian model with habits in consumption

In this paper we consider the implications of habits for optimal monetary policy, when those habits either exist at the level of the aggregate basket of consumption goods (‘superficial’ habits) or at the level of individual goods (‘deep’ habits: see Ravn et al., 2006). External habits generate an additional distortion in the economy and create new trade-offs for optimal policy, as the policy maker does not respond as aggressively to technology shocks in order to avoid exacerbating the habits externality. This can dramatically affect both the parameterization of optimal simple rules, as well as their determinacy properties. These effects are particularly strong when habits are of the deep kind.

Equilibrium Dynamics in the Neoclassical Growth Model with Habit Formation and Elastic Labor Supply

This note analyzes the equilibrium dynamics in the neoclassical growth model with habit-forming preferences and elastic labor supply. Habits enter into utility in a multiplicative way. The specification of the habit formation process comprises the particular cases of internal and external habits. Existence, uniqueness and saddle-path stability of the steady state are proved analytically.

Habit Formation Heterogeneity: Implications for Aggregate Asset Pricing

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.

Monetary policy, rule-of-thumb consumers and external habits: a G7 comparison

This article extends the standard New Keynesian Dynamic Stochastic General Equilibrium (DSGE) model to agents who cannot smooth consumption (i.e. spenders) and are affected by external consumption habits. Although these assumptions are not new, their joint consideration strongly affects some theoretical and empirical results addressed by the recent literature. By deriving closed-form solutions, we identify different demand regimes and show that they are characterized by specific features regarding dynamic stability and monetary policy effectiveness. We also evaluate our model by stochastic simulations obtained from the Bayesian parameters estimates for the Group of Seven (G7) economies. From posterior impulse responses, we address the empirical relevance of the different regimes and provide comparative evidence on the heterogeneity of monetary policy effects among countries.

Internal and external habits and news-driven business cycles

An internal habit can be a source of news-driven business cycles, positive comovements in consumption, labor, investment, and output from the news about the future, whereas an external habit cannot.

A Habit‐Based Explanation of the Exchange Rate Risk Premium

ABSTRACTThis paper presents a model that reproduces the uncovered interest rate parity puzzle. Investors have preferences with external habits. Countercyclical risk premia and procyclical real interest rates arise endogenously. During bad times at home, when domestic consumption is close to the habit level, the representative investor is very risk averse. When the domestic investor is more risk averse than her foreign counterpart, the exchange rate is closely tied to domestic consumption growth shocks. The domestic investor therefore expects a positive currency excess return. Because interest rates are low in bad times, expected currency excess returns increase with interest rate differentials.

Real Business-Cycle Model with Habits: Empirical Investigation

This paper empirically investigates the ability of a real business-cycle model with nonseparabilities in consumption and leisure and external habits both in consumption and leisure to fit the postwar US data. The results indicate a strong but fast-dying habit in leisure, and a somewhat weaker but more persistent habit in consumption. Intratemporal nonseparabilities in consumption and leisure play an important role in driving the response of real variables to a productivity shock. Adding capital adjustment costs to the model with nonseparabilities in consumption and leisure and external habits both in consumption and leisure changes the responses of real variables to a productivity shock, however, in a way similar to that documented for the models with capital adjustment costs and habit formation in consumption. The estimated persistence of the productivity shock is quite modest, which may be the factor that drives a procyclical response of hours worked to the positive productivity shock even when habit in consumption is strong.

A note on external habits and efficiency in the AK model

This paper examines the implications for equilibrium efficiency of alternative formulations of habit formation in the AK model with external habits. Agent’s utility depends on how her current consumption compares to a reference consumption level—the habits stock—determined by average past consumption in the economy. We first prove that perfect substitutability between consumption and habits along the equilibrium path is necessary and sufficient for efficiency. Then, we prove that the competitive equilibrium is efficient if and only if habits enter utility in a subtractive form.

Risk Aversion, the Labor Margin, and Asset Pricing in DSGE Models

In dynamic equilibrium models, the household's labor margin has dramatic effects on risk aversion, and hence asset prices, even when utility is additively separable between consumption and labor. This paper derives simple, closed-form expressions for risk aversion that take into account the household's labor margin. Ignoring the labor margin can wildly overstate the household's true aversion to risk. Risk premia on assets priced with the stochastic discount factor increase essentially linearly with risk aversion, so measuring risk aversion correctly is crucial for asset pricing in the model. Closed-form expressions for risk aversion in DSGE models with generalized recursive preferences and internal and external habits are also derived.

Internal vs. External Habit Formation in a Growing Economy with Overlapping Generations

This paper explores the roles of internal and external habit formation in a simple model of endogenous growth with overlapping generations. Unlike the representative agent settings in which the distinction between internal and external habits may not yield significant qualitative differences in working of the model economy, we show that the internal and external habit persistence in overlapping generations economies may have qualitatively different effects on the steady-state characterization as well as on the dynamic behavior of the economy. We also confirm that in an overlapping generations framework, whether the habits in the utility function takes subtractive or multiplicative forms may be critical both for long-run growth and for transitional dynamics.

Habit formation and chaotic dynamics in an n-dimensional cash-in-advance economy

This paper investigates the global dynamics of an n-dimensional cash-in-advance model where external habits persist for n periods. We find that habit formation is an important determinant to the dynamic property of the economy and identifies conditions generating entropic chaos. Our results indicate that the possibility of chaotic motion increases with the depreciation rate of habits.

Solving an asset pricing model with hybrid internal and external habits, and autocorrelated Gaussian shocks

We derive an explicit formula for the price-dividend ratio of a generalized version of Abel’s asset pricing model. This model is generalized in two ways: first, consumption (dividend) growth is assumed to be an AR(1) process subject to Gaussian random shocks, and second, the investor’s preferences are allowed to be a convex combination of internal and external habits. With an internal habit weight, 50%, and a coefficient of risk aversion, 3.25, simulation results match the historic US equity premium and risk free interest rate.

Explaining Asset Prices with External Habits and Wage Rigidities in a DSGE Model

In this paper, I investigate the scope of a model with exogenous habit formation - or `catching up with the Joneses`, see Abel (1990) - to generate the observed equity premium as well as other key macroeconomic facts. Along the way, I derive restrictions for four out of eight parameters for a rather general preference specification of habit formation by imposing consistency with long-run growth, the leisure share, the aggregate Frisch elasticity of labor supply, the observed risk-free rate, and the observed Sharpe ratio. I show that a DSGE model with (exogenous and lagged) habits in both leisure and consumption, but not necessarily with additional persistence, is well capable of matching the observed asset market facts as well as macro facts, provided one allows for moderate real wage stickiness and provided one allows for sufficient curvature on preferences, as dictated by the asset market observations. Without wage stickiness, delivery on both the asset pricing implications as well as the macroeconomic implications seems to be much harder.