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Risky Habits: On Risk Sharing, Habit Formation, and the Interpretation of International Consumption Correlations

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  • Jeffrey C. Fuhrer
  • Michael W. Klein

Abstract

Standard international economic models with life cycle/permanent income consumption behavior predict that international portfolio diversification leads to high bilateral consumption correlations. Thus international consumption correlations have been empirically estimated as a test of international portfolio diversification and risk sharing. In this paper we investigate the international consumption correlations generated by a more general model which incorporates habit formation in consumption. We show that, in the presence of common interest rate movements, habit formation itself can generate positive international consumption correlations even in the absence of any international risk sharing. Empirical evidence presented in this paper suggests habit formation characterizes consumption behavior among most of the G-7 countries. Thus, the extent of international portfolio diversification may be even lower than that suggested by previous research which studied international consumption correlations.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 6735.

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Date of creation: Sep 1998
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Publication status: published as Fuhrer, Jeffrey C. and Michael W. Klein. "Risky Habits: On Risk Sharing, Habit Formation, And The Interpretation Of International Consumption Correlations," Review of International Economics, 2006, v14(4,Sep), 722-740.
Handle: RePEc:nbr:nberwo:6735

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  1. Devereux, Michael B. & Gregory, Allan W. & Smith, Gregor W., 1992. "Realistic cross-country consumption correlations in a two-country, equilibrium, business cycle model," Journal of International Money and Finance, Elsevier, Elsevier, vol. 11(1), pages 3-16, February.
  2. Backus, David K & Kehoe, Patrick J & Kydland, Finn E, 1992. "International Real Business Cycles," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 100(4), pages 745-75, August.
  3. Jeffrey C. Fuhrer, 1998. "An Optimising Model for Monetary Policy Analysis: Can Habit Formation Help?," RBA Research Discussion Papers, Reserve Bank of Australia rdp9812, Reserve Bank of Australia.
  4. Christopher D. Carroll & Jody Overland & David N. Weil, 1995. "Saving and growth with habit formation," Finance and Economics Discussion Series, Board of Governors of the Federal Reserve System (U.S.) 95-42, Board of Governors of the Federal Reserve System (U.S.).
  5. Evans, Paul & Karras, Georgios, 1997. "International integration of capital markets and the cross-country divergence of per capita consumption," Journal of International Money and Finance, Elsevier, Elsevier, vol. 16(5), pages 681-697, September.
  6. Michael R. Pakko, 1998. "Characterizing Cross-Country Consumption Correlations," The Review of Economics and Statistics, MIT Press, vol. 80(1), pages 169-174, February.
  7. Lewis, Karen K, 1996. "What Can Explain the Apparent Lack of International Consumption Risk Sharing?," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 104(2), pages 267-97, April.
  8. Alan C. Stockman & Linda L. Tesar, 1991. "Tastes and technology in a two-country model of the business cycle: explaining international co-movements," Working Paper 9019, Federal Reserve Bank of Cleveland.
  9. Tesar, Linda L., 1993. "International risk-sharing and non-traded goods," Journal of International Economics, Elsevier, Elsevier, vol. 35(1-2), pages 69-89, August.
  10. Anderson, Gary & Moore, George, 1985. "A linear algebraic procedure for solving linear perfect foresight models," Economics Letters, Elsevier, Elsevier, vol. 17(3), pages 247-252.
  11. Baxter, Marianne & Jermann, Urban J, 1997. "The International Diversification Puzzle Is Worse Than You Think," American Economic Review, American Economic Association, American Economic Association, vol. 87(1), pages 170-80, March.
  12. Campbell, John Y. & Mankiw, N. Gregory, 1991. "The response of consumption to income : A cross-country investigation," European Economic Review, Elsevier, Elsevier, vol. 35(4), pages 723-756, May.
  13. Baxter, Marianne & Crucini, Mario J, 1993. "Explaining Saving-Investment Correlations," American Economic Review, American Economic Association, American Economic Association, vol. 83(3), pages 416-36, June.
  14. Mansoorian, Arman, 1998. "Habits and durability in consumption, and the dynamics of the current account," Journal of International Economics, Elsevier, Elsevier, vol. 44(1), pages 69-82, February.
  15. Maurice Obstfeld., 1993. "Are Industrial-Country Consumption Risks Globally Diversified?," Center for International and Development Economics Research (CIDER) Working Papers, University of California at Berkeley C93-014, University of California at Berkeley.
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