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

57 Pages Posted: 24 Jul 2000 Last revised: 27 Aug 2010

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

Multiple version iconThere are 2 versions of this paper

Date Written: January 1995

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 latter feature 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.

Suggested Citation

Campbell, John Y. and Cochrane, John H., By Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior (January 1995). NBER Working Paper No. w4995. Available at SSRN: https://ssrn.com/abstract=226593

John Campbell (Contact Author)

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John Cochrane

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