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Consumption Commitments: Neoclassical Foundations for Habit Formation

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  • Adam Szeidl
  • Raj Chetty

Abstract

This paper studies consumption and portfolio choice in a model where agents have neoclassical preferences over two consumption goods, one of which involves a commitment in that its consumption can only be adjusted infrequently. Aggregating over a population of such agents implies dynamics identical to those of a representative consumer economy with habit formation utility. In particular, aggregate consumption is a slow-moving average of past consumption levels, and risk aversion is amplified because the marginal utility of wealth is determined by excess consumption over the prior commitment level. We test the model's prediction that commitments amplify risk aversion by using home tenure (years spent in current house) as a proxy for commitment: Recent home purchasers are unlikely to move in the near future, and are therefore more constrained by their housing commitment. We use a set of control groups to establish that the timing of marital shocks such as marriage and divorce can be used to create exogenous variation in home tenure conditional on age and wealth. Using these marital shocks as instruments, we find that the average investor reallocates $1,500 from safe assets to stocks per year in a house. Hence, recent home purchasers have highly amplified risk aversion, suggesting that real commitments are a quantitatively powerful source of habit-like behavior.

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Bibliographic Info

Paper provided by Society for Economic Dynamics in its series 2005 Meeting Papers with number 122.

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Date of creation: 2005
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Handle: RePEc:red:sed005:122

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Keywords: Portfolio choice; Housing; Risk Aversion; Microfoundations;

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Citations

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Cited by:
  1. Andrew Postlewaite & Larry Samuelson & Dan Silverman, 2006. "Consumption Commitments and Employment Contracts," Levine's Bibliography 321307000000000145, UCLA Department of Economics.
  2. Cochrane, John H., 2005. "Financial Markets and the Real Economy," Foundations and Trends(R) in Finance, now publishers, vol. 1(1), pages 1-101, July.
  3. Andrew Postlewaite & Larry Samuelson & Dan Silverman, 2006. "Consumption Commitments and Employment Contracts, Fourth Version," PIER Working Paper Archive 07-020, Penn Institute for Economic Research, Department of Economics, University of Pennsylvania, revised 09 Jul 2007.
  4. Raj Chetty & Adam Szeidl, 2007. "Consumption Commitments and Risk Preferences," The Quarterly Journal of Economics, MIT Press, vol. 122(2), pages 831-877, 05.
  5. Ricardo Reis, 2004. "Inattentive Consumers," Working Papers 135, Princeton University, Woodrow Wilson School of Public and International Affairs, Discussion Papers in Economics..
  6. Andrew Benito, 2007. "Housing equity as a buffer: evidence from UK households," Bank of England working papers 324, Bank of England.
  7. Gene Amromin, 2008. "Precautionary Savings Motives and Tax Efficiency of Household Portfolios: An Empirical Analysis," NBER Chapters, in: Tax Policy and the Economy, Volume 22, pages 5-41 National Bureau of Economic Research, Inc.
  8. Carroll, Christopher D. & Otsuka, Misuzu & Slacalek, Jiri, 2010. "How large are housing and financial wealth effects? A new approach," Working Paper Series 1283, European Central Bank.
  9. Morris A. Davis & Robert F. Martin, 2005. "Housing, house prices, and the equity premium puzzle," Finance and Economics Discussion Series 2005-13, Board of Governors of the Federal Reserve System (U.S.).
  10. Davidoff, Thomas, 2010. "Home equity commitment and long-term care insurance demand," Journal of Public Economics, Elsevier, vol. 94(1-2), pages 44-49, February.
  11. Markus K. Brunnermeier & Stefan Nagel, 2006. "Do Wealth Fluctuations Generate Time-varying Risk Aversion? Micro-Evidence on Individuals' Asset Allocation," NBER Working Papers 12809, National Bureau of Economic Research, Inc.

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