Testing Habits in an Asset Pricing Model

Abstract

We develop an asset pricing model with external habit formation. The model predicts that the effect of consumption shocks on the equity premium depends on the business cycle. We test this empirical implication using a VAR model of the U.S. postwar economy whose parameters are estimated conditioning on Markov-switching regimes that shift according to the business cycle phases. The results show that the response of the equity premium to consumption shocks is insignificantly different across the business cycle phases of the economy. We interpret this result as evidence against the habit formation hypothesis.

Keywords: Habit formation, Equity premium, Business cycles, Markov-switching models, Regime-dependent impulse response functions

JEL Classification: E21, E32, E44, G11, G12