Habit Formation Heterogeneity: Implications for Aggregate Asset Pricing
38 Pages Posted: 17 Dec 2011 Last revised: 11 Jun 2012
Date Written: March 1, 2012
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 (2012). 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.
Keywords: asset pricing, consumption-based asset pricing models, external habit, internal habit, heterogeneity, time nonseparability, general equilibrium, recursive solution
JEL Classification: C68, D58, D91, E21, E44, G11, G12
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