Internal vs. External Habit Formation: The Relative Importance for Asset Pricing

33 Pages Posted: 5 Mar 2007 Last revised: 24 Sep 2011

See all articles by Olesya V. Grishchenko

Olesya V. Grishchenko

Board of Governors of the Federal Reserve System

Date Written: January 7, 2010

Abstract

I present a generalized model that structurally nests both "catching up with the Joneses" (external habit) and "time non-separable" (internal habit) preference specifications. The model's asset pricing implications are confronted with the observed aggregate US consumption and asset returns data to determine the relative importance of "catching up with the Joneses" and internal habit formation. I show that long-horizon aggregate returns are more consistent with long-run habit as opposed to "catching up with the Joneses" preferences. This result supports the findings of Parker and Julliard (2005) that the ultimate consumption risk explains more of the cross-sectional variation in stock returns.

Keywords: Asset pricing, consumption-based asset pricing models, time non-separabilities, external habit, internal habit, long horizon returns

JEL Classification: E21, E44, G12

Suggested Citation

Grishchenko, Olesya V., Internal vs. External Habit Formation: The Relative Importance for Asset Pricing (January 7, 2010). Journal of Economics and Business, Vol. 62, pp. 176-194. Available at SSRN: https://ssrn.com/abstract=968284

Olesya V. Grishchenko (Contact Author)

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States
202-452-2981 (Phone)

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