Working Paper: CEPR ID: DP5602
Authors: Josep Pijoanmas
Abstract: Habit formation has been proposed as a possible solution to the equity premium puzzle. This paper extends the class of models that support the habits explanation in order to account for heterogeneity in earnings, wealth, habits and consumption. I find that habit formation does indeed increase the equity premium. However, contrary to earlier results, the habit hypothesis does not imply a price for risk as big as the one measured in the data. There are three reasons for this. First, households in a habits economy modify their consumption/savings decision. Second, they modify their portfolio choice. These two changes in behavior diminish the consumption fluctuations faced by households. And third, the composition of the set of agents pricing risk in the economy changes so that relatively better self-insured households end up pricing risk.
Keywords: Equity Premium; Habit Formation; Incomplete Markets
JEL Codes: C68; D52; E21; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| habit formation (I12) | equity premium (G12) |
| habit formation (I12) | consumption behavior (D10) |
| consumption behavior (D10) | equity premium (G12) |
| habit formation (I12) | utility losses from consumption fluctuations (D11) |
| utility losses from consumption fluctuations (D11) | equity premium (G12) |
| habit formation (I12) | precautionary savings (D14) |
| habit formation (I12) | changes in portfolio composition (G11) |
| habit formation (I12) | shift in pricing agents composition (D49) |