Abstract

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By Force of Habit: A Consumption-Based Explanation of Plantation of Aggregate Stock Market Behavior


John Y. Campbell


Harvard University - Department of Economics; National Bureau of Economic Research (NBER)

John H. Cochrane


University of Chicago - Booth School of Business; National Bureau of Economic Research (NBER)

May 1998

Center for Research in Security Prices (CRSP) Working Paper No. 412

Abstract:     
We present a consumption-based model that explains the procyclical variation of stock prices, the long-horizon predictability of excess stock returns, and the countercyclical variation of stock market volatility. Our model has an i.i.d. consumption growth driving process, and adds a slow-moving external habit to the standard power utility function. The latterfeature produces cyclical variation in risk aversion, and hence in the prices of risky assets. Our model also predicts many of the difficulties that beset the standard power utility model, including Euler equation rejections, no correlation between mean consumption growth and interest rates, very high estimates of risk aversion, and pricing errors that are larger than those of the static CAPM. Our model captures much of the history of stock prices, given only consumption data. Since our model captures the equity premium, it implies that fluctuations have important welfare costs. Unlike many habit-persistence models, our model does not necessarily produce cyclical variation in the risk free interest rate, nor does it produce an extremely skewed distribution or negative realizations of the marginal rate of substitution.

Number of Pages in PDF File: 67

JEL Classification: G12, E21

working papers series


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Date posted: June 26, 1997  

Suggested Citation

Campbell, John Y. and Cochrane, John H., By Force of Habit: A Consumption-Based Explanation of Plantation of Aggregate Stock Market Behavior (May 1998). Center for Research in Security Prices (CRSP) Working Paper No. 412. Available at SSRN: http://ssrn.com/abstract=1870 or http://dx.doi.org/10.2139/ssrn.1870

Contact Information

John Y. Campbell
Harvard University - Department of Economics ( email )
Littauer Center
Room 213
Cambridge, MA 02138
United States
617-496-6448 (Phone)
617-495-7730 (Fax)
HOME PAGE: http://scholar.harvard.edu/campbell
National Bureau of Economic Research (NBER)
1050 Massachusetts Avenue
Cambridge, MA 02138
United States
John H. Cochrane (Contact Author)
University of Chicago - Booth School of Business ( email )
5807 S. Woodlawn Avenue
Chicago, IL 60637
United States
773-702-3059 (Phone)
773-702-0458 (Fax)
HOME PAGE: http://faculty.chicagobooth.edu/john.cochrane/research/Papers/

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National Bureau of Economic Research (NBER)
1050 Massachusetts Avenue
Cambridge, MA 02138
United States
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