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Risky Habits: on Risk Sharing, Habit Formation, and the Interpretation of International Consumption Correlations

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  • Jeffrey C. Fuhrer
  • Michael W. Klein

Abstract

Standard international economic models with life cycle/permanent income consumption behavior predict that international portfolio diversification leads to high bilateral consumption correlations. Thus international consumption correlations have been empirically estimated as a test of international portfolio diversification and risk sharing. In this paper we investigate the international consumption correlations generated by a more general model which incorporates habit formation in consumption. We show that, in the presence of a common shock, habit formation itself can generate positive international consumption correlations even in the absence of any international risk sharing. Empirical evidence presented in this paper suggests habit formation characterizes consumption behavior among most of the G-7 countries. Thus, the extent of international portfolio diversification may be even lower than that suggested by previous research which studied international consumption correlations. Copyright � 2006 The Authors; Journal compilation � 2006 Blackwell Publishing Ltd.

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Article provided by Wiley Blackwell in its journal Review of International Economics.

Volume (Year): 14 (2006)
Issue (Month): 4 (09)
Pages: 722-740

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Handle: RePEc:bla:reviec:v:14:y:2006:i:4:p:722-740

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  1. Backus, David K & Kehoe, Patrick J & Kydland, Finn E, 1992. "International Real Business Cycles," Journal of Political Economy, University of Chicago Press, vol. 100(4), pages 745-75, August.
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  7. Maurice Obstfeld., 1993. "Are Industrial-Country Consumption Risks Globally Diversified?," Center for International and Development Economics Research (CIDER) Working Papers C93-014, University of California at Berkeley.
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  9. Michael R. Pakko, 1994. "Characterizing cross-country consumption correlations," Working Papers 1994-026, Federal Reserve Bank of St. Louis.
  10. Alan C. Stockman & Linda L. Tesar, 1991. "Tastes and technology in a two-country model of the business cycle: explaining international co-movements," Working Paper 9019, Federal Reserve Bank of Cleveland.
  11. Evans, Paul & Karras, Georgios, 1997. "International integration of capital markets and the cross-country divergence of per capita consumption," Journal of International Money and Finance, Elsevier, vol. 16(5), pages 681-697, September.
  12. Mansoorian, Arman, 1998. "Habits and durability in consumption, and the dynamics of the current account," Journal of International Economics, Elsevier, vol. 44(1), pages 69-82, February.
  13. Tesar, Linda L., 1993. "International risk-sharing and non-traded goods," Journal of International Economics, Elsevier, vol. 35(1-2), pages 69-89, August.
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  15. Jody Overland & Christopher D. Carroll & David N. Weil, 2000. "Saving and Growth with Habit Formation," American Economic Review, American Economic Association, vol. 90(3), pages 341-355, June.
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