Habit Persistence In Consumption Research Articles

The consumption–investment decision of a prospect theory household: A two-period model with an endogenous second period reference level

In this paper we analyze the two-period consumption–investment decision of a household with prospect theory preferences and an endogenous second period reference level which captures habit persistence in consumption and in the current consumption reference level. In particular, we examine three types of household depending on how the household’s current consumption reference level relates to a given threshold which is equal to the average discounted endowment income. The first type of household has a relatively low reference level (less ambitious household) and can avoid relative consumption losses in both periods. The second type of household (balanced household) always consumes exactly its reference levels. The third type of household has a relatively high reference level (more ambitious household) and cannot avoid to incur relative consumption losses, either now or in the future. Note that these households may act very differently from one another and thus there will often be a diversity of behavior. For all three types we examine how the household reacts to changes in: income (e.g., income fall caused by recession or taxation of endowment income), persistence to consumption, the first period reference level and the degree of loss aversion. Among others we find that the household increases its exposure to risky assets in good economic times if it is less ambitious and in bad economic times if it is more ambitious. We also find that in some cases more income can lead to less happiness. In addition, the less ambitious household and the more ambitious household with a higher time preference will be less happy with a rising persistence in consumption while the more ambitious household with a lower time preference will be happier if it sticks more to its consumption habits. Finally, the household’s happiness decreases with an increasing consumption reference level and thus not comparing at all will lead to the highest level of happiness. In addition, the sensitivity of happiness with respect to the reference level gets larger the closer the household moves to the threshold level, and it is smaller for less ambitious households than for more ambitious households due to loss aversion.

Estimating Excess Sensitivity and Habit Persistence in Consumption Using Greenbook Forecasts

AbstractIn this paper, we revisit the issue of excess sensitivity of consumption to income and address the weak instrument problem that is well documented in this literature. Using quarterly data for the US economy, we first highlight the weak instrument problem by showing that the use of conventional instruments tends to overestimate the share of rule‐of‐thumb consumers. To address this weak instrument problem, we propose a new instrument for endogenous disposable income growth in the consumption function, namely, the Greenbook forecast of real disposable income growth. We show that this instrument encompasses the information contained in the conventional set of instruments, and is a superior predictor of income growth. We find that using our proposed instrument ameliorates the weak instrument problem and provides a much smaller estimate for the rule‐of‐thumb consumers. We also extend our empirical framework to allow for habit persistence and provide an estimate for this important parameter of the consumption function. Finally, we use a time‐varying specification of consumption function that allows for endogenous regressors, and document a decline in the share of rule‐of‐thumb consumers and a rise in the habit‐persistence parameter in the US over our sample period.

Monetary policy volatility shocks in Brazil

This paper provides empirical evidence of the impact of changes in volatility of monetary policy in Brazil using a model where the time-varying volatility of shocks directly affects the level of observed variables. Contrary to the literature, an increase in monetary policy volatility results in higher inflation, combined with reduction in output. Qualitative differences of impulse responses functions are explained using a calibrated small-scale dynamic model, where the habit persistence in consumption, combined with the design of monetary policy, plays a key role in results. Firms tend to increase prices under higher volatility, in order to avoid costs of resetting over time. Working capital constraints amplify the effects of interest rate volatility shocks on prices.

From Price Puzzle to Neo-Fisherianism

Neo-Fisher effect states that an increase in nominal rate of interest which deemed to be permanent, will lead to a rise in inflation both in the short-run as well as in the long-run. In this paper, we study the possibility of occurrence of neo-Fisher effect in a new-Keynesian model. For this purpose, we develop a closed economy new-Keynesian model which account for cost channel of monetary policy, consumption persistence in agents’ utility function, and real wage rigidity. Our analytical results reveal that in the presence of cost channel of monetary policy, neo-Fisher effect occur even when the monetary innovation shock is purely stochastic. In our calibration exercises we show that the inclusion of habit persistence in consumption and real wage rigidities in the model help in eliminating the neo-Fisher effect despite the presence of cost channel of monetary policy and the persistence in the monetary innovation shock. We also found that in case of permanent monetary innovation shock, we cannot break the neo-Fisher effect.

Active monetary policy and the slowdown: Evidence from DSGE based Indian aggregate demand and supply

We explore reasons for the strongly asymmetric Indian monetary transmission and response to other shocks, compared to those of the United States, obtained in a standard New Keynesian Dynamic Stochastic General Equilibrium (DSGE) model. While counterfactual analysis moderates other impulse responses, it suggests large cost shocks remain a primitive cause of inflation, and the strong transmission comes from large interest rate changes. Reducing the variance of the interest rate shock can significantly moderate the large output cost. Asymmetric excess volatility due to preference and technology shocks is reduced on introducing regime switching between multiple steady-states. The estimated model including multiple regimes is therefore used to obtain aggregate demand and aggregate supply schedules, which incorporate the policy reaction function, and to identify their shifts during the Indian slowdown. The correlation between factors shifting aggregate demand and supply is estimated. Since it is negative it aggravates the shocks. The post 2011 slowdown is explained by severe demand contraction in response to adverse supply shocks. Habit persistence in consumption changes the slope of both aggregate demand and supply curves significantly.

Estimating Excess Sensitivity and Habit Persistence in Consumption Using Greenbook Forecast as an Instrument

In this paper, we revisit the issue of excess sensitivity of consumption to income and address the weak instrument problem that is well documented in this literature. Using quarterly data for the U.S. economy, we first highlight the weak instrument problem by showing that the use of conventional instruments tends to overestimate the share of rule-of-thumb consumers. To address this weak instrument problem, we propose a new instrument for endogenous disposable income growth in the consumption function, namely, the Greenbook forecast of real disposable income growth. We show that this instrument encompasses the information contained in the conventional set of instruments, and is a superior predictor of income growth. We find that using our proposed instrument ameliorates the weak instrument problem and provides a much smaller estimate for the rule-of-thumb consumers. We also extend our empirical framework to allow for habit persistence and provide an estimate for this important parameter of the consumption function. Finally, we use a time-varying specification of consumption function that allows for endogenous regressors, and document a decline in the share of rule-of-thumb consumers and a rise in the habit-persistence parameter in the U.S. over our sample period. We find that an increase in credit growth and supplementary income benefits are negatively correlated with share of rule-of-thumb consumers, whereas they are positively correlated with habit persistence parameter.

NOMINAL RIGIDITIES, RESIDENTIAL INVESTMENT, AND ADJUSTMENT COSTS

Evidence suggests that durable goods and residential housing are more flexibly priced than nondurables and services. Using a standard sticky price general equilibrium model, Barsky, House, and Kimball [American Economic Review 97(3) (2007), 984–998] demonstrate that if durable goods are flexibly priced and nondurables are sticky, then a monetary contraction leads to an expansion in production in the durable sector. This is wildly at odds with the empirical evidence. This paper demonstrates that if three features are added to the model (sticky nominal wages, housing construction adjustment costs, and habit persistence in consumption), it delivers sectoral implications that are broadly consistent with the data.

An Assessment of Dynamic Behavior in the U.S. Catfish Market: An Application of the Generalized Dynamic Rotterdam Model

The generalized dynamic Rotterdam model was used in estimating U.S. demand for disaggregated catfish. The overall goal was to examine habit persistence in consumption and to determine the adjustment process in demand. Results indicated that it took up to 1 month for catfish-product demand to fully adjust to changes in expenditures and prices. Additionally, habit persistence played a role in demand where present consumption of a given product was positively affected by past consumption of that product. Consequently, U.S. catfish demand was significantly more elastic in the long-ran.

Habit persistence in consumption and the demand for money

We consider a representative–consumer setting where the ratio (respectively difference) between current consumption and the level of habit yields utility. Money demand is well-defined in the difference-specification but not in the ratio-specification for plausible values of the parameter measuring habit.

ANOTHER VIEW OF THE J-CURVE

Most of empirical studies find evidence of the J-Curve, but recent results cast doubt over its standard explanation. By addressing the countercyclicality of the current account and its dynamic link with the terms of trade, this paper revisits the J-Curve phenomenon using a two-good dynamic optimizing small open economy model allowing for a habit-forming behavior and capital adjustment costs. While the nonmonotonic adjustment of the current account relies on the degree of habit persistence in consumption and the magnitude of capital installation costs after an unanticipated terms of trade worsening, we show that the sizes of the long-run intertemporal elasticity of substitution under time nonseparable preferences and the import content of real consumption and investment matter as well after a temporary perturbation. As a consequence of an intertemporal speculation effect and an inertia effect, the small country reaches the long-term equilibrium with higher foreign assets after a short-lived terms of trade worsening.

Time-to-Build, Time-to-Plan, Habit-Persistence, and the Liquidity Effect

The general inability of sticky-price monetary business cycle models to generate liquidity effects has been noted in the recent literature by authors such as Christiano (1991), Christiano and Eichenbaum (1992a, 1995), King and Watson (1996), and Bernanke and Mihov (1998b). This paper develops a sticky-price monetary business cycle model that is capable of generating an empirically plausible liquidity effect. Time-to-build and time-to-plan in investment together with habit-persistence in consumption are the features of the model that allow it to produce this result.

Time-to-build, time-to-plan, habit-persistence, and the liquidity effect

The inability of sticky-price monetary business cycle models to generate liquidity effects has been extensively documented by a number of authors. This paper develops a sticky-price monetary business cycle model with investment gestation lags and habit-persistence in consumption that is capable of generating an empirically plausible liquidity effect.

The Delayed Response to a Technology Shock: A Flexible Price Explanation

I present empirical evidence of how the U.S. economy, including per-capita hours worked, responds to a technology shock. In particular, I present results based on permanent changes to a constructed direct measure of technological change for U.S. manufacturing industries. Based on empirical evidence, some claim that hours worked declines and never recovers in response to a positive technology shock. This paper's empirical evidence suggests that emphasizing the drop in hours worked is misdirected. Because the sharp drop in hours is not present here, the emphasis rather should be on the small (perhaps negative) initial response followed by a subsequent large positive response. Investment, consumption, and output have similar dynamic responses. In response to a positive technology shock, a standard flexible price model would have an immediate increase in hours worked. Therefore, such a model is inconsistent with the empirical dynamic responses. I show, however, that a flexible price model with habit persistence in consumption and certain kinds of capital adjustment costs can better match the empirical responses. Some recent papers have critiqued the use of long run VARs to identify the dynamic responses to a technology shock. In particular they report that, when long run VARs are applied to data simulated from particular economic models, the point estimates of the impulse responses may be imprecisely estimated. However, based on additional simulation evidence, I find that, although the impact response may be imprecisely estimated, a finding of a delayed response is much more likely when the true model response also has a delayed response.

A Formal Model of Krugman's Intuition on the J-Curve

We use a two-good dynamic intertemporal general equilibrium model to formalize the economic intuition of Krugman about the explanation of the J-curve phenomenon in terms of habit persistence in consumption and sluggishness in capital adjustment. The results difier markedly according to the permanence or temporary nature of the shock. A short-lived terms of trade worsening may give rise to a once-for-all decrease in the marginal utility of wealth, a hump-shape response of real expense when the perturbation is at work and a deflnitely higher level of consumption at the new steady-state. Habitual standard of living and welfare are raised through the combination of an intertemporal speculation, habit persistence, and hysteresis efiects. In accordance with recent empirical results, investment is procyclical, H-L-M efiect holds, net foreign assets adjustment exhibits a J-curve, current account surplus is associated with a fall in real income. From an analytical viewpoint, a new consistent procedure to study temporary shocks in continuous time leads to formal solutions that allow to investigate accurately transitional dynamics in a complex dynamic system, comparing transitory and permanent perturbations analytically, underscoring hysteresis phenomenon, and bringing out the determinants of short and long-term reactions of macroeconomic aggregates.

Inflation Inertia - the Role of Multiple, Interacting Pricing Rigidities

Monetary models with nominal rigidities are known to have difficulties in matching some important features of the empirical impulse responses of monetary policy shocks, especially inertia of the inflation rate and the hump-shaped responses of consumption, investment and output. To remedy this, the literature has mostly employed a combination of backward-looking price setting and of not always uncontroversial real rigidities. This paper addresses the problem without a need to depart from rational forward-looking price setting in a fully specified microfounded model. While price and wage setters are subject to nominal rigidities, they can choose a more generalprice path than in conventional models. Combined with econometrically identified highly persistent monetary policy shocks, this gives rise to far more persistent inflation and real interest rates. Second, a small number of simple and intuitively appealing real rigidities goes a long way in matching empirical impulse responses for real variables. These are habit persistence in consumption, time to build investment with an initial quadratic capital stock adjustment cost, and a long chain of intermediate input supply relationships, with nominal rigidities cascading from upstream to downstream.

The Delayed Response To A Technology Shock: A Flexible Price Explanation

I present empirical evidence of how the U.S. economy, including per-capita hours worked, responds to a technology shock. In particular, I present results based on permanent changes to a constructed direct measure of technological change for U.S. manufacturing industries. Based on empirical evidence, some claim that hours worked declines and never recovers in response to a positive technology shock. This paper's empirical evidence suggests that emphasizing the drop in hours worked is misdirected. Because the sharp drop in hours is not present here, the emphasis rather should be on the small (perhaps negative) initial response followed by a subsequent large positive response. Investment, consumption, and output have similar dynamic responses. In response to a positive technology shock, a standard flexible price model would have an immediate increase in hours worked. Therefore, such a model is inconsistent with the empirical dynamic responses. I show, however, that a flexible price model with habit persistence in consumption and certain kinds of capital adjustment costs can better match the empirical responses. Some recent papers have critiqued the use of long run VARs to identify the dynamic responses to a technology shock. In particular they report that, when long run VARs are applied to data simulated from particular economic models, the point estimates of the impulse responses may be imprecisely estimated. However, based on additional simulation evidence, I find that, although the impact response may be imprecisely estimated, a finding of a delayed response is much more likely when the true model response also has a delayed response.

Habit Persistence in Consumption in a Sticky Price Model of the Business Cycle

This paper examines the role of habit persistence in consumption in explaining persistent responses of inflation and output to money growth shocks. A MIU-model with a separable utility function is embedded into a stochastic DGE model with sticky prices. It is shown that for a high degree of habit persistence consumption displays a pronounced and hump-shaped response while the volatility falls short empirical estimates. The behavior of output and inflation does not change compared to a model without habit formation. Empirically plausible degrees of habit persistence still cause consumption to be persistent but do not improve the performance for other macroeconomic aggregates. Most variables are cyclical and too strongly correlated with output. Overall habit persistence in consumption cannot explain the observed reaction of the macroeconomic aggregates to monetary shocks.

Habit persistence and welfare gains from international asset trade

We introduce habit formation in a model that studies the link between international trade in financial assets, economic growth, and welfare. As with time separable preferences, asset trade increases the mean growth rate, but it also increases growth-volatility. We demonstrate that the welfare gain from asset trade is lower with habit persistence in consumption. This reflects that the habit-forming households perceive the higher growth-volatility as a higher cost to obtain increased average growth. Calibrating the model to data for North America and Western Europe, we find that habit persistence lowers welfare gains of financial integration by about 40–50%.

Time-to-Build, Time-to-Plan, Habit-Persistence, and the Liquidity Effect

The general inability of sticky-price monetary business cycle models to generate liquidity effects has been noted in the recent literature by authors such as Christiano (1991), Christiano and Eichenbaum (1992a, 1995), King and Watson (1996), and Bernanke and Mihov (1998b). This paper develops a sticky-price monetary business cycle model that is capable of generating an empirically plausible liquidity effect. Time-to-build and time-to-plan in investment together with habit-persistence in consumption are the features of the model that allow it to produce this result.

Correlations Between Real Interest Rates and Output in a Dynamic International Model-Evidence From G-7 Countries

This paper examines the extent to which a dynamic international general equilibrium model can account for observed movements in real interest rates and interest rate differentials. Using data for Group of Seven, the study finds that measured real interest rates are countercyclical in a single country and that the contemporaneous cross-correlations between international real interest differentials and output growth spreads are negative. Predictions of the baseline model are, however, inconsistent with the data. Extending the benchmark model to include habit persistence in consumption improves the match between theory and data.