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Does Intrinsic Habit Formation Actually Resolve the Equity Premium Puzzle?

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  • David A. Chapman

    (University of Texas, Austin)

Abstract

Constantinides (1990) describes a simple model of intrinsic habit formation that appears to resolve the "equity premium puzzle" of Mehra and Prescott (1985). This finding is particularly important, since it has motivated a broader consideration of the implications of habit formation preferences in dynamic equilibrium models. However, consumption growth actually behaves very differently pre- and post-1948, and the explanatory power of the habit formation model is driven by the pre-1948 data. Using data from 1949 to 2000, constructed in a manner comparable to Mehra and Prescott (1985), I demonstrate that intrinsic habit cannot rationalize the unconditional moments of discrete consumption and real asset returns with values of the risk aversion coefficient that are less than four times larger than the values found in Constantinides (1990), for any feasible calibration of the model. (Copyright: Elsevier)

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File URL: http://dx.doi.org/10.1006/redy.2001.0155
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Bibliographic Info

Article provided by Elsevier for the Society for Economic Dynamics in its journal Review of Economic Dynamics.

Volume (Year): 5 (2002)
Issue (Month): 3 (July)
Pages: 618-645

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Handle: RePEc:red:issued:v:5:y:2002:i:3:p:618-645

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References

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  1. Lettau, M. & Uhlig, H., 1995. "Can Habit Formation be Reconciled with Business Cycle Facts?," Discussion Paper 1995-54, Tilburg University, Center for Economic Research.
  2. Mankiw, N.G. & Zeldes, S.P., 1990. "The Consumption Of Stockholders And Non-Stockholders," Weiss Center Working Papers 23-90, Wharton School - Weiss Center for International Financial Research.
  3. Donald W.K. Andrews & Werner Ploberger, 1992. "Optimal Tests When a Nuisance Parameter Is Present Only Under the Alternative," Cowles Foundation Discussion Papers 1015, Cowles Foundation for Research in Economics, Yale University.
  4. Campbell, John, 1986. "Bond and Stock Returns in a Simple Exchange Model," Scholarly Articles 3122544, Harvard University Department of Economics.
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  6. S. Grossman & R. Shiller, . "The Determinants of the Variability of Stock Market Price," Rodney L. White Center for Financial Research Working Papers 18-80, Wharton School Rodney L. White Center for Financial Research.
  7. Jermann, Urban J., 1998. "Asset pricing in production economies," Journal of Monetary Economics, Elsevier, vol. 41(2), pages 257-275, April.
  8. Otrok, C. & Ravikumar, B. & Whiteman, C., 1998. "Habit Formation: A Resolution of the Equity Premium Puzzle?," Working Papers 98-04, University of Iowa, Department of Economics.
  9. R. Mehra & E. Prescott, 2010. "The equity premium: a puzzle," Levine's Working Paper Archive 1401, David K. Levine.
  10. John Heaton & Deborah Lucas, 2000. "Portfolio Choice and Asset Prices: The Importance of Entrepreneurial Risk," Journal of Finance, American Finance Association, vol. 55(3), pages 1163-1198, 06.
  11. Kocherlakota, N., 1995. "The Equity Premium: It's Still a Puzzle," Working Papers 95-05, University of Iowa, Department of Economics.
  12. Lawrence J. Christiano & Martin Eichenbaum & David Marshall, 1987. "The Permanent Income Hypothesis Revisited," NBER Working Papers 2209, National Bureau of Economic Research, Inc.
  13. Donald W.K. Andrews, 1990. "Tests for Parameter Instability and Structural Change with Unknown Change Point," Cowles Foundation Discussion Papers 943, Cowles Foundation for Research in Economics, Yale University.
  14. 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.
  15. Heaton, John, 1993. "The Interaction between Time-Nonseparable Preferences and Time Aggregation," Econometrica, Econometric Society, vol. 61(2), pages 353-85, March.
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  18. G. Constantinides, 1990. "Habit formation: a resolution of the equity premium puzzle," Levine's Working Paper Archive 1397, David K. Levine.
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Citations

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Cited by:
  1. Stefano Athanasoulis & Oren Sussman, 2007. "Habit formation and the equity–premium puzzle: a skeptical view," Annals of Finance, Springer, vol. 3(2), pages 193-212, March.
  2. René Garcia & Richard Luger, 2009. "Risk Aversion, Intertemporal Substitution, and the Term Structure of Interest Rates," CIRANO Working Papers 2009s-20, CIRANO.
  3. Santiago Budria & Antonia Diaz, 2006. "Term Premium And Equity Premium In Economies With Habit Formation," Economics Working Papers we065522, Universidad Carlos III, Departamento de Economía.
  4. Santiago Budría & Antonia Díaz, 2006. "Term and Equity Premium in Economies with Habit Formation," Working Papers 2006-23, FEDEA.
  5. Mary C. Daly & Daniel J. Wilson, 2006. "Keeping up with the Joneses and staying ahead of the Smiths: evidence from suicide data," Working Paper Series 2006-12, Federal Reserve Bank of San Francisco.
  6. Arjen Siegmann, 2003. "Shortfall allowed: loss aversion and habit formation," WO Research Memoranda (discontinued) 741, Netherlands Central Bank, Research Department.
  7. Collard, Fabrice & Fève, Patrick & Ghattassi, Imen, 2003. "Solving Asset Pricing Models with Habit Persistence," IDEI Working Papers 245, Institut d'Économie Industrielle (IDEI), Toulouse.

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