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Optimal Endowment Destruction under Campbell-Cochrane Habit Formation

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  • Lars Ljungqvist
  • Harald Uhlig

Abstract

Campbell and Cochrane (1999) formulate a model that successfully explains a wide variety of asset pricing puzzles, by augmenting the standard power utility function with a time-varying subsistence level, or "external habit", that adapts nonlinearly to current and past average consumption in the economy. This paper demonstrates, that this comes at the "price" of several unusual implications. For example, we calculate that a society of agents with the preferences and endowment process of Campbell and Cochrane (1999) would experience a welfare gain equivalent to a permanent increase of nearly 16% in consumption, if the government enforced one month of fasting per year, reducing consumption by 10 percent then. We examine and explain these features of the preferences in detail. We numerically characterize the solution to the social planning problem. We conclude that Campbell-Cochrance preferences will provide for interesting macroeconomic modeling challenges, when endogenizing aggregate consumption choices and government policy.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 14772.

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Date of creation: Mar 2009
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Handle: RePEc:nbr:nberwo:14772

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  1. Moore, Michael J. & Roche, Maurice J., 2002. "Less of a puzzle: a new look at the forward forex market," Journal of International Economics, Elsevier, vol. 58(2), pages 387-411, December.
  2. John Y. Campbell & John H. Cochrane, 1994. "By Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior," CRSP working papers 412, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
  3. Fatih Guvenen, 2009. "A Parsimonious Macroeconomic Model for Asset Pricing," NBER Working Papers 15243, National Bureau of Economic Research, Inc.
  4. Wachter, Jessica A., 2005. "Solving models with external habit," Finance Research Letters, Elsevier, vol. 2(4), pages 210-226, December.
  5. Ravi Bansal & A. Ronald Gallant & George Tauchen, 2007. "Rational Pessimism, Rational Exuberance, and Asset Pricing Models," Review of Economic Studies, Oxford University Press, vol. 74(4), pages 1005-1033.
  6. 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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Cited by:
  1. Stig V. Møller, 2007. "Habit persistence: Explaining cross sectional variation in returns and time-varying expected returns," CREATES Research Papers 2007-07, School of Economics and Management, University of Aarhus.
  2. Nengjiu Ju & Jianjun Miao, . "Ambiguity, Learning, and Asset Returns," Boston University - Department of Economics - Working Papers Series wp2009-014, Boston University - Department of Economics.
  3. Pierre Perron† & Tatsuma Wada, 2005. "Let’s Take a Break: Trends and Cycles in US Real GDP?," Boston University - Department of Economics - Working Papers Series WP2005-031, Boston University - Department of Economics, revised Oct 2005.
  4. Grishchenko, Olesya V., 2010. "Internal vs. external habit formation: The relative importance for asset pricing," Journal of Economics and Business, Elsevier, vol. 62(3), pages 176-194, May.
  5. Pancrazi, Roberto, 2013. "How Beneficial was the Great Moderation After All?," The Warwick Economics Research Paper Series (TWERPS) 1016, University of Warwick, Department of Economics.
  6. Santiago Budria, 2005. "An Exploration of Asset Returns in a Production Economy with Relative Habits," Finance 0505004, EconWPA.
  7. Christophe Chamley, 2006. "Complementarities in information acquisition with short-term trades," Boston University - Department of Economics - Working Papers Series WP2006-042, Boston University - Department of Economics.

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