Can Habit Formation Be Reconciled with Business Cycle Facts?

Posted: 25 Aug 1998

See all articles by Harald Uhlig

Harald Uhlig

University of Chicago - Department of Economics

Martin Lettau

University of California - Haas School of Business; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER)

Abstract

Many asset pricing puzzles can be explained when habit formation is added to standard preferences. We show that utility functions with a habit then gives rise to a puzzle of consumption volatility in place of the asset pricing puzzles when agents can choose consumption and labor optimally in response to more fundamental shocks. We show that the consumption reaction to technology shocks are too small by an order of magnitude when a utility includes a habit. Alternative models with consistent and exogenous but stochastic labor input are considered. A model with persistent technology shocks and stochastic labor is shown to be potentially consistent with substantial consumption variability as well as procyclical labor input and labor productivity even when a habit is present.

JEL Classification: E44, G12

Suggested Citation

Uhlig, Harald and Lettau, Martin, Can Habit Formation Be Reconciled with Business Cycle Facts?. Available at SSRN: https://ssrn.com/abstract=6604

Harald Uhlig

University of Chicago - Department of Economics ( email )

1101 East 58th Street
Chicago, IL 60637
United States

Martin Lettau (Contact Author)

University of California - Haas School of Business ( email )

Haas School of Business
545 Student Services Building
Berkeley, CA 94720
United States
5106436349 (Phone)

HOME PAGE: http://faculty.haas.berkeley.edu/lettau/

Centre for Economic Policy Research (CEPR)

London
United Kingdom

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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