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Habits, Rationality and Myopia in the Life-Cycle Consumption Function

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Muellbauer, John

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Abstract

This paper investigates the role of habits in the consumption function. Two types of habits are considered: rational and myopic, these being distinctions which have long been made in the literature on systems of demand equations. In both cases past consumption affects current preferences, thus breaking the intertemporal separability of preferences often assumed by economists. If habits are rational, consumers are aware of the effect of their current consumption decisions on their future marginal rates of substitution. If habits are myopic, consumers lack this awareness and this may result in a time inconsistency in their behaviour. We explore the consequences of these two types of habituation, both for traditional "solved-out" consumption functions and for consumption functions in the "Euler equation" form popularized by Hall (1978). The two types of habitual behaviour yield representations of the aggregate consumption function which are in principle observationally distinct. We estimate the Euler-equation form of the consumption function for quarterly United States data over the period 1954-1981. We also consider time aggregation and other specification issues, such as those posed by liquidity constraints.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 112.

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Date of creation: Jun 1986
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Handle: RePEc:cpr:ceprdp:112

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Keywords: Consumption Function Myopic Habit Formation Rational Habit Formation

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  1. Lettau, Martin & Ludvigson, Sydney, 2001. "Understanding Trend and Cycle in Asset Values: Bulls, Bears and the Wealth Effect on Consumption," CEPR Discussion Papers 3104, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
  2. Alessie, R. & Teppa, F., 2002. "Saving and habit formation: : evidence from Dutch panel data," Discussion Paper 62, Tilburg University, Center for Economic Research. [Downloadable!]
    Other versions:
  3. Antoine Bommier & Bertrand Villeneuve, 2004. "Risk Aversion and the Value of Risk to Life," CESifo Working Paper Series CESifo Working Paper No. , CESifo GmbH. [Downloadable!]
  4. Petar D. Vujanovic, 1999. "HABITS AND THE SAVINGS-GROWTH RELATIONSHIP Why US Personal Savings Rates Are At Historic Lows," Macroeconomics 9905002, EconWPA. [Downloadable!]
  5. Croix,David,de la & Urbain,Jean-Pierre, 1996. "Intertemporal substitution in import demand and habit formation ," Research Memoranda 003, Maastricht : METEOR, Maastricht Research School of Economics of Technology and Organization. [Downloadable!]
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  6. Jiri Slacalek, 2006. "International Wealth Effects," Computing in Economics and Finance 2006 425, Society for Computational Economics. [Downloadable!]
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  7. Christopher D. Carroll & Misuzu Otsuka & Jirka Slacalek, 2006. "How Large Is the Housing Wealth Effect? A New Approach," Economics Working Paper Archive 535, The Johns Hopkins University,Department of Economics. [Downloadable!]
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  8. Martin Sommer, 2001. "Sentiment Predictable Income and Habits in the Dynamics of Aggregate Consumption," Economics Working Paper Archive 458, The Johns Hopkins University,Department of Economics. [Downloadable!]
  9. BOMMIER, Antoine & ROCHET, Jean-Charles, 2003. "Risk Aversion and Planning Horizon," IDEI Working Papers 204, Institut d'Économie Industrielle (IDEI), Toulouse, revised Nov 2004. [Downloadable!]
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  10. Karen E. Dynan, 2000. "Habit Formation in Consumer Preferences: Evidence from Panel Data," American Economic Review, American Economic Association, vol. 90(3), pages 391-406, June. [Downloadable!] (restricted)
  11. Joseph W. Gruber, 2002. "Productivity shocks, habits, and the current account," International Finance Discussion Papers 733, Board of Governors of the Federal Reserve System (U.S.). [Downloadable!]
  12. Jim Malley & Hassan Molana, . "The Permanent Income Hypothesis Revisited. Reconciling Evidence from Aggregate Data with the Representative Consumer Behaviour," Working Papers 9708, Department of Economics, University of Glasgow. [Downloadable!]
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  13. Roy Cromb & Emilio Fernandez-Corugedo, . "Long-term interest rates, wealth and consumption," Bank of England working papers 243, Bank of England. [Downloadable!]
  14. Christopher D Carroll, 2000. "Solving Consumption Models with Multiplicative Habits," Economics Working Paper Archive 421, The Johns Hopkins University,Department of Economics. [Downloadable!]
    Other versions:
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