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Utility Function and Optimum Consumption in the models with Habit Formation and Catching up with the Joneses

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  • Roman Naryshkin
  • Matt Davison
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    Abstract

    This paper analyzes popular time-nonseparable utility functions that describe "habit formation" consumer preferences comparing current consumption with the time averaged past consumption of the same individual and "catching up with the Joneses" (CuJ) models comparing individual consumption with a cross-sectional average consumption level. Few of these models give reasonable optimum consumption time series. We introduce theoretically justified utility specifications leading to a plausible consumption behavior to show that habit formation preferences must be described by a power CRRA utility function different from the exponential CARA used for CuJ.

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    File URL: http://arxiv.org/pdf/0909.3655
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    Bibliographic Info

    Paper provided by arXiv.org in its series Papers with number 0909.3655.

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    Date of creation: Sep 2009
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    Handle: RePEc:arx:papers:0909.3655

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    1. Smith, William T., 2002. "Consumption and saving with habit formation and durability," Economics Letters, Elsevier, Elsevier, vol. 75(3), pages 369-375, May.
    2. Andrew B. Abel, . "Asset Prices Under Habit Formation and Catching Up With the Jones," Rodney L. White Center for Financial Research Working Papers, Wharton School Rodney L. White Center for Financial Research 01-90, Wharton School Rodney L. White Center for Financial Research.
    3. Harald Uhlig & Lars Ljungqvist, 2000. "Tax Policy and Aggregate Demand Management under Catching Up with the Joneses," American Economic Review, American Economic Association, American Economic Association, vol. 90(3), pages 356-366, June.
    4. Kahneman, Daniel & Tversky, Amos, 1979. "Prospect Theory: An Analysis of Decision under Risk," Econometrica, Econometric Society, Econometric Society, vol. 47(2), pages 263-91, March.
    5. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, Elsevier, vol. 15(2), pages 145-161, March.
    6. Francisco Alvarez-Cuadrado & Goncalo Monteiro & Stephen Turnovsky, 2004. "Habit Formation, Catching Up with the Joneses, and Economic Growth," Working Papers, University of Washington, Department of Economics UWEC-2004-09-P, University of Washington, Department of Economics, revised Jan 2004.
    7. Gali, J., 1992. "Keeping Up with the Joneses: Consumption Externalities, Portfolio Choice and Asset Prices," Papers 92-22, Columbia - Graduate School of Business.
    8. Gómez Manuel A., 2007. "Equilibrium Efficiency in the Ramsey Model with Habit Formation," Studies in Nonlinear Dynamics & Econometrics, De Gruyter, vol. 11(2), pages 1-34, May.
    9. G. Constantinides, 1990. "Habit formation: a resolution of the equity premium puzzle," Levine's Working Paper Archive 1397, David K. Levine.
    10. Schoemaker, Paul J H, 1982. "The Expected Utility Model: Its Variants, Purposes, Evidence and Limitations," Journal of Economic Literature, American Economic Association, vol. 20(2), pages 529-63, June.
    11. Clark, Andrew E. & Frijters, Paul & Shields, Michael A., 2007. "Relative Income, Happiness and Utility: An Explanation for the Easterlin Paradox and Other Puzzles," IZA Discussion Papers 2840, Institute for the Study of Labor (IZA).
    12. Sundaresan, Suresh M, 1989. "Intertemporally Dependent Preferences and the Volatility of Consumption and Wealth," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 2(1), pages 73-89.
    13. Jeffrey C. Fuhrer, 2000. "Habit Formation in Consumption and Its Implications for Monetary-Policy Models," American Economic Review, American Economic Association, American Economic Association, vol. 90(3), pages 367-390, June.
    14. Gali, Jordi, 1990. "Finite horizons, life-cycle savings, and time-series evidence on consumption," Journal of Monetary Economics, Elsevier, Elsevier, vol. 26(3), pages 433-452, December.
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