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

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

67 Pages Posted: 26 Jun 1997  

John Y. Campbell

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

John H. Cochrane

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

Date Written: May 1998

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.

JEL Classification: G12, E21

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: https://ssrn.com/abstract=1870 or http://dx.doi.org/10.2139/ssrn.1870

John Y. Campbell

Harvard University - Department of Economics ( email )

Littauer Center
Room 213
Cambridge, MA 02138
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HOME PAGE: http://scholar.harvard.edu/campbell

National Bureau of Economic Research (NBER)

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John H. Cochrane (Contact Author)

Hoover Institution ( email )

Stanford, CA 94305-6010
United States
6507236708 (Phone)

HOME PAGE: http://faculty.chicagobooth.edu/john.cochrane/index.htm

National Bureau of Economic Research (NBER)

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Cambridge, MA 02138
United States

University of Chicago - Booth School of Business ( email )

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Chicago, IL 60637
United States
773-702-0458 (Fax)

HOME PAGE: http://faculty.chicagobooth.edu/john.cochrane/research/Papers/

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