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

  • Harald Uhlig

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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File URL: http://www.aeaweb.org/articles.php?doi=10.1257/aer.97.2.239
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Article provided by American Economic Association in its journal American Economic Review.

Volume (Year): 97 (2007)
Issue (Month): 2 (May)
Pages: 239-243

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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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  1. 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.
  2. 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.
  3. repec:cup:macdyn:v:6:y:2002:i:2:p:242-65 is not listed on IDEAS
  4. 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.
  5. 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.
  6. Blanchard, Olivier J & Galí, Jordi, 2005. "Real Wage Rigidities and the New Keynesian Model," CEPR Discussion Papers 5375, C.E.P.R. Discussion Papers.
  7. 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.
  8. Sy-Ming Guu & Kenneth L. Judd, 2001. "Asymptotic methods for asset market equilibrium analysis," Economic Theory, Springer, vol. 18(1), pages 127-157.
  9. Fatih Guvenen, 2009. "A Parsimonious Macroeconomic Model for Asset Pricing," NBER Working Papers 15243, National Bureau of Economic Research, Inc.
  10. Robert Shimer, 2005. "The Cyclical Behavior of Equilibrium Unemployment and Vacancies," American Economic Review, American Economic Association, vol. 95(1), pages 25-49, March.
  11. 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).
  12. Robert E. Hall, 2005. "Employment Fluctuations with Equilibrium Wage Stickiness," American Economic Review, American Economic Association, vol. 95(1), pages 50-65, March.
  13. Jermann, Urban J., 1998. "Asset pricing in production economies," Journal of Monetary Economics, Elsevier, vol. 41(2), pages 257-275, April.
  14. repec:dgr:kubcen:199554 is not listed on IDEAS
  15. 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.
  16. Robert E. Lucas, Jr. & 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.).
  17. 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.
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