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External habit: Anything goes

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  • Pohl, Walt

Abstract

This paper explores the expressive ability of the external habit mechanism. I show that whenever the stochastic discount factor (SDF) is a function of aggregate consumption, there exists a representative agent external habit model that replicates that SDF. I also show that within this framework the other utility function parameters become indeterminate, in that a different choice of power utility can lead to the exact same SDF. The indeterminacy arises from an ambiguity in the SDF between the externality and individual consumption.

Suggested Citation

  • Pohl, Walt, 2016. "External habit: Anything goes," Economics Letters, Elsevier, vol. 146(C), pages 140-142.
    • Handle: RePEc:eee:ecolet:v:146:y:2016:i:c:p:140-142
    DOI: 10.1016/j.econlet.2016.07.019
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    References listed on IDEAS

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    1. Abel, Andrew B, 1990. "Asset Prices under Habit Formation and Catching Up with the Joneses," American Economic Review, American Economic Association, vol. 80(2), pages 38-42, May.
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    4. John Y. Campbell & John Cochrane, 1999. "Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior," Journal of Political Economy, University of Chicago Press, vol. 107(2), pages 205-251, April.
    5. Thomas D. Tallarini, Jr. & Harold H. Zhang, 2005. "External Habit and the Cyclicality of Expected Stock Returns," The Journal of Business, University of Chicago Press, vol. 78(3), pages 1023-1048, May.
    6. Adrien Verdelhan, 2010. "A Habit‐Based Explanation of the Exchange Rate Risk Premium," Journal of Finance, American Finance Association, vol. 65(1), pages 123-146, February.
    7. Wachter, Jessica A., 2006. "A consumption-based model of the term structure of interest rates," Journal of Financial Economics, Elsevier, vol. 79(2), pages 365-399, February.
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    More about this item

    Keywords

    External habit; Consumption-based asset pricing;

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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