External Habit in a Production Economy: A Model of Asset Prices and Consumption Volatility Risk
67 Pages Posted: 13 Aug 2014 Last revised: 3 Feb 2017
Date Written: February 2, 2016
A standard real business cycle model with external habit and capital adjustment costs matches a long list of asset price and business cycle moments: equity, firm value, and risk-free rate volatility; the equity premium; excess return predictability; consumption growth predictability; basic moments of consumption, output, and investment; and more. The model also generates endogenous consumption volatility risk. Precautionary savings motives make consumption sensitive to shocks in bad times, leading to countercyclical volatility, even with homoskedastic technology shocks. Habit acts as countercyclical leverage, which amplifies this channel. Habit also implies high risk aversion, which amplifies the stock price response.
Keywords: time-varying risk premia, the equity premium puzzle, time-varying consumption volatility, habit, precautionary saving
JEL Classification: G12, E21, E30
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