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An Exploration of Asset Returns in a Production Economy with Relative Habits

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Author Info
Santiago Budria (University of Madeira & CEEAplA)

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Abstract

This paper explores asset returns in a production economy with habit forming households. I show that a model with capital adjustment costs and relative habits is consistent with salient financial facts, such as the equity premium, the market price of risk, and the riskfree interest rate. These predictions are not at odds with good business cycle predictions. In the model economy investment is strongly procyclical and more volatile than output, which in turn is more volatile than consumption. Moreover, consumption growth is positively autocorrelated and negatively (positively) correlated with future (past) stock returns.

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Paper provided by EconWPA in its series Finance with number 0505004.

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Length: 30 pages
Date of creation: 03 May 2005
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Handle: RePEc:wpa:wuwpfi:0505004

Note: Type of Document - pdf; pages: 30
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Web page: http://129.3.20.41

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Related research
Keywords: Equity premium; Business cycles; Habit persistence.;

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Find related papers by JEL classification:
G12 - Financial Economics - - General Financial Markets - - - Asset Pricing
E22 - Macroeconomics and Monetary Economics - - Macroeconomics: Consumption, Saving, Production, Employment, and Investment - - - Capital; Investment; Capacity

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  1. Christopher D. Carroll & Jody Overland & David N. Weil, 1995. "Saving and growth with habit formation," Finance and Economics Discussion Series 95-42, Board of Governors of the Federal Reserve System (U.S.).
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  2. Morten Ravn & Stephanie Schmitt-Grohe & Martin Uribe, 2006. "Deep Habits," Review of Economic Studies, Blackwell Publishing, vol. 73(1), pages 195-218, 01. [Downloadable!] (restricted)
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  3. Boldrin, Michele & Christiano, Lawrence J. & Fisher, Jonas D.M., 1997. "Habit Persistence And Asset Returns In An Exchange Economy," Macroeconomic Dynamics, Cambridge University Press, vol. 1(02), pages 312-332, June. [Downloadable!]
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  4. Jeffrey C. Fuhrer, 2000. "Habit Formation in Consumption and Its Implications for Monetary-Policy Models," American Economic Review, American Economic Association, vol. 90(3), pages 367-390, June. [Downloadable!] (restricted)
  5. Judd, Kenneth L., 1992. "Projection methods for solving aggregate growth models," Journal of Economic Theory, Elsevier, vol. 58(2), pages 410-452, December. [Downloadable!] (restricted)
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  6. Alonso-Carrera, Jaime & Caballe, Jordi & Raurich, Xavier, 2005. "Growth, habit formation, and catching-up with the Joneses," European Economic Review, Elsevier, vol. 49(6), pages 1665-1691, August. [Downloadable!] (restricted)
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  7. Diaz, Antonia & Pijoan-Mas, Josep & Rios-Rull, Jose-Victor, 2003. "Precautionary savings and wealth distribution under habit formation preferences," Journal of Monetary Economics, Elsevier, vol. 50(6), pages 1257-1291, September. [Downloadable!] (restricted)
  8. Lettau, Martin & Uhlig, Harald, 2002. "The Sharpe Ratio And Preferences: A Parametric Approach," Macroeconomic Dynamics, Cambridge University Press, vol. 6(02), pages 242-265, April. [Downloadable!]
  9. Abel, A.B., 1990. "Asset Prices Under Habit Formation And Catching Up With The Joneses," Weiss Center Working Papers 1-90, Wharton School - Weiss Center for International Financial Research.
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  10. Andreas Hornstein & Harald Uhlig, 2000. "What is the Real Story for Interest Rate Volatility?," German Economic Review, Blackwell Publishing, vol. 1(1), pages 43-67, 02. [Downloadable!] (restricted)
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  11. TallariniJr., Thomas D., 2000. "Risk-sensitive real business cycles," Journal of Monetary Economics, Elsevier, vol. 45(3), pages 507-532, June. [Downloadable!] (restricted)
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  12. John Y. Campbell & John H. Cochrane, 1995. "By Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior," NBER Working Papers 4995, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  13. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March. [Downloadable!] (restricted)
  14. Jermann, Urban J., 1998. "Asset pricing in production economies," Journal of Monetary Economics, Elsevier, vol. 41(2), pages 257-275, April. [Downloadable!] (restricted)
  15. Abel, Andrew B., 1999. "Risk premia and term premia in general equilibrium," Journal of Monetary Economics, Elsevier, vol. 43(1), pages 3-33, February. [Downloadable!] (restricted)
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  16. Weil, Philippe, 1989. "The equity premium puzzle and the risk-free rate puzzle," Journal of Monetary Economics, Elsevier, vol. 24(3), pages 401-421, November. [Downloadable!] (restricted)
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  17. Christopher D Carroll, 2000. "Solving Consumption Models with Multiplicative Habits," Economics Working Paper Archive 421, The Johns Hopkins University,Department of Economics. [Downloadable!]
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  18. Martin Lettau & Harald Uhlig, 2000. "Can Habit Formation be Reconciled with Business Cycle Facts?," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 3(1), pages 79-99, January. [Downloadable!] (restricted)
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  19. Lars Ljungqvist & Harald Uhlig, 2009. "Optimal Endowment Destruction under Campbell-Cochrane Habit Formation," NBER Working Papers 14772, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  20. Constantinides, George M, 1990. "Habit Formation: A Resolution of the Equity Premium Puzzle," Journal of Political Economy, University of Chicago Press, vol. 98(3), pages 519-43, June. [Downloadable!] (restricted)
  21. Andrew B. Abel, 2006. "Equity Premia with Benchmark Levels of Consumption: Closed-Form Results," NBER Working Papers 12290, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  22. Michele Boldrin & Lawrence J. Christiano & Jonas D. M. Fisher, 2000. "Habit persistence, asset returns and the business cycle," Staff Report 280, Federal Reserve Bank of Minneapolis. [Downloadable!]
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