Optimal Endowment Destruction Under Campbell-Cochrane Habit Formation

29 Pages Posted: 5 Mar 2009 Last revised: 6 Mar 2009

See all articles by Lars Ljungqvist

Lars Ljungqvist

Stockholm School of Economics - Department of Economics; Centre for Economic Policy Research (CEPR); IZA Institute of Labor Economics

Harald Uhlig

University of Chicago - Department of Economics

Date Written: March 2009

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 subsistence level, or "external habit", that adapts nonlinearly to current and past average consumption in the economy. This paper demonstrates, that this comes at the "price" of several unusual implications. For example, we calculate that a society of agents with the preferences and endowment process of Campbell and Cochrane (1999) would experience a welfare gain equivalent to a permanent increase of nearly 16% in consumption, if the government enforced one month of fasting per year, reducing consumption by 10 percent then. We examine and explain these features of the preferences in detail. We numerically characterize the solution to the social planning problem. We conclude that Campbell-Cochrance preferences will provide for interesting macroeconomic modeling challenges, when endogenizing aggregate consumption choices and government policy.

Suggested Citation

Ljungquist, Lars and Uhlig, Harald, Optimal Endowment Destruction Under Campbell-Cochrane Habit Formation (March 2009). NBER Working Paper No. w14772, Available at SSRN: https://ssrn.com/abstract=1352952

Lars Ljungquist (Contact Author)

Stockholm School of Economics - Department of Economics ( email )

P.O. Box 6501
Sveavagen 65
S-113 83 Stockholm
Sweden
+46 8 736 9209 (Phone)
+46 8 313 207 (Fax)

Centre for Economic Policy Research (CEPR)

London
United Kingdom

IZA Institute of Labor Economics

P.O. Box 7240
Bonn, D-53072
Germany

Harald Uhlig

University of Chicago - Department of Economics ( email )

1101 East 58th Street
Chicago, IL 60637
United States

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