Working Paper: NBER ID: w14772
Authors: Lars Ljungqvist; Harald Uhlig
Abstract: Campbell and Cochrane (1999) formulate a model that successfully explains a wide variety of asset pricing puzzles, by augmenting the standard power utility function with a time-varying subsistence level, or "external habit", that adapts nonlinearly to current and past average consumption in the economy. This paper demonstrates, that this comes at the "price" of several unusual implications. For example, we calculate that a society of agents with the preferences and endowment process of Campbell and Cochrane (1999) would experience a welfare gain equivalent to a permanent increase of nearly 16% in consumption, if the government enforced one month of fasting per year, reducing consumption by 10 percent then. We examine and explain these features of the preferences in detail. We numerically characterize the solution to the social planning problem. We conclude that Campbell-Cochrance preferences will provide for interesting macroeconomic modeling challenges, when endogenizing aggregate consumption choices and government policy.
Keywords: Campbell-Cochrane preferences; endowment destruction; welfare gains; consumption dynamics
JEL Codes: C61; E21; E44; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| government intervention (endowment destruction) (H13) | increase in welfare (higher consumption) (D69) |
| endowment destruction (H84) | welfare improvement (I38) |
| size of endowment destruction (G19) | welfare effects vary (D69) |
| consumption increases (E20) | habit level can decrease (I12) |
| government interventions (H53) | optimal consumption processes reevaluation (D15) |