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Explaining Asset Prices with External Habits and Wage Rigidities in a DSGE Model

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  • Harald Uhlig

Abstract

In this paper, I investigate the scope of a model with exogenous habit formation -- or ``catching up with the Joneses'', see Abel (1990) -- to generate the observed equity premium as well as other key macroeconomic facts. Along the way, I derive restrictions for four out of eight parameters for a rather general preference specification of habit formation by imposing consistency with long-run growth, the leisure share, the aggregate Frisch elasticity of labor supply, the observed risk-free rate, and the observed Sharpe ratio. I show that a DSGE model with (exogenous and lagged) habits in both leisure and consumption, but not necessarily with additional persistence, is well capable of matching the observed asset market facts as well as macro facts, provided one allows for moderate real wage stickiness and provided one allows for sufficient curvature on preferences, as dictated by the asset market observations. Without wage stickiness, delivery on both the asset pricing implications as well as the macroeconomic implications seems to be much harder.
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Suggested Citation

  • Harald Uhlig, 2007. "Explaining Asset Prices with External Habits and Wage Rigidities in a DSGE Model," American Economic Review, American Economic Association, vol. 97(2), pages 239-243, May.
  • Handle: RePEc:aea:aecrev:v:97:y:2007:i:2:p:239-243
    Note: DOI: 10.1257/aer.97.2.239
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    References listed on IDEAS

    as
    1. M. Fatih Guvenen, 2003. "A Parsimonious Macroeconomic Model for Asset Pricing: Habit Formation or Cross-sectional Heterogeneity?," RCER Working Papers 499, University of Rochester - Center for Economic Research (RCER).
    2. Abel, Andrew B, 1990. "Asset Prices under Habit Formation and Catching Up with the Joneses," American Economic Review, American Economic Association, vol. 80(2), pages 38-42, May.
    3. Robert Shimer, 2005. "The Cyclical Behavior of Equilibrium Unemployment and Vacancies," American Economic Review, American Economic Association, vol. 95(1), pages 25-49, March.
    4. Sy-Ming Guu & Kenneth L. Judd, 2001. "Asymptotic methods for asset market equilibrium analysis," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 18(1), pages 127-157.
    5. Robert E. Lucas & N. Gregory Mankiw & Michael Woodford, 2005. "Panel discussion: understanding price determination: where are we now? where should we be going?," Proceedings, Board of Governors of the Federal Reserve System (U.S.).
    6. repec:cup:macdyn:v:6:y:2002:i:2:p:242-65 is not listed on IDEAS
    7. repec:dgr:kubcen:199554 is not listed on IDEAS
    8. Lawrence J. Christiano & Michele Boldrin & Jonas D. M. Fisher, 2001. "Habit Persistence, Asset Returns, and the Business Cycle," American Economic Review, American Economic Association, vol. 91(1), pages 149-166, March.
    9. Olivier Blanchard & Jordi Galí, 2007. "Real Wage Rigidities and the New Keynesian Model," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 39(s1), pages 35-65, February.
    10. John Y. Campbell & John H. Cochrane, 1994. "By force of habit: a consumption-based explanation of aggregate stock market behavior," Working Papers 94-17, Federal Reserve Bank of Philadelphia.
    11. Harald Uhlig & Lars Ljungqvist, 2000. "Tax Policy and Aggregate Demand Management under Catching Up with the Joneses," American Economic Review, American Economic Association, vol. 90(3), pages 356-366, June.
    12. 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.
    13. Jermann, Urban J., 1998. "Asset pricing in production economies," Journal of Monetary Economics, Elsevier, vol. 41(2), pages 257-275, April.
    14. John Y. Campbell & John Cochrane, 1999. "Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior," Journal of Political Economy, University of Chicago Press, vol. 107(2), pages 205-251, April.
    15. 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.
    16. Robert E. Hall, 2005. "Employment Fluctuations with Equilibrium Wage Stickiness," American Economic Review, American Economic Association, vol. 95(1), pages 50-65, March.
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    More about this item

    JEL classification:

    • E24 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Employment; Unemployment; Wages; Intergenerational Income Distribution; Aggregate Human Capital; Aggregate Labor Productivity
    • E30 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - General (includes Measurement and Data)
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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