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Internal vs. external habit formation: The relative importance for asset pricing

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  • Grishchenko, Olesya V.

Abstract

I present a generalized model that structurally nests both "catching up with the Joneses" (external habit) and "time nonseparable" (internal habit) preference specifications. The model's asset pricing implications are confronted with the observed aggregate US consumption and asset returns data to determine the relative importance of "catching up with the Joneses" and internal habit formation. I show that long-horizon aggregate returns are more consistent with long-run habit as opposed to "catching up with the Joneses" preferences. This result supports the findings of Parker and Julliard (2005) that the ultimate consumption risk explains more of the cross-sectional variation in stock returns.

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  • Grishchenko, Olesya V., 2010. "Internal vs. external habit formation: The relative importance for asset pricing," Journal of Economics and Business, Elsevier, vol. 62(3), pages 176-194, May.
    • Handle: RePEc:eee:jebusi:v:62:y::i:3:p:176-194
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    Cited by:

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    2. Gómez Manuel A., 2010. "Endogenous Growth, Habit Formation and Convergence Speed," The B.E. Journal of Macroeconomics, De Gruyter, vol. 10(1), pages 1-32, January.
    3. Kakeu, Johnson & Nguimkeu, Pierre, 2017. "Habit formation and exhaustible resource risk-pricing," Energy Economics, Elsevier, vol. 64(C), pages 1-12.
    4. Masako Ikefuji & Kazuo Mino, 2009. "Internal vs. External Habit Formation in a Growing Economy with Overlapping Generations," KIER Working Papers 676, Kyoto University, Institute of Economic Research.
    5. Carolina Achury & Sylwia Hubar & Christos Koulovatianos, 2012. "Saving Rates and Portfolio Choice with Subsistence Consumption," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 15(1), pages 108-126, January.
    6. Constantin Chilarescu & Ioana Viasu, 2016. "A Closed-form Solution of a Two-sector Endogenous Growth Model with Habit Formation," Australian Economic Papers, Wiley Blackwell, vol. 55(2), pages 112-127, June.
    7. Òscar Jordà & Moritz Schularick & Alan M. Taylor, 2019. "The Total Risk Premium Puzzle?," Working Paper Series 2019-10, Federal Reserve Bank of San Francisco.
    8. Olivier Coibion & Yuriy Gorodnichenko, 2011. "Strategic Interaction among Heterogeneous Price-Setters in an Estimated DSGE Model," The Review of Economics and Statistics, MIT Press, vol. 93(3), pages 920-940, August.
    9. Damonte Marco & Cardullo Gabriele, 2022. "The end of the Equity Premium Puzzle? An analysis of the European Financial Markets," Journal of Finance and Investment Analysis, SCIENPRESS Ltd, vol. 11(2), pages 1-2.
    10. Eduard Dubin & Olesya V. Grishchenko & Vasily Kartashov, 2012. "Habit formation heterogeneity: Implications for aggregate asset pricing," Finance and Economics Discussion Series 2012-07, Board of Governors of the Federal Reserve System (U.S.).
    11. Battauz, Anna & De Donno, Marzia & Ortu, Fulvio, 2011. "Intertemporal asset pricing and the marginal utility of wealth," Journal of Mathematical Economics, Elsevier, vol. 47(2), pages 227-244, March.
    12. Tzu-Ming Liu, 2020. "Habit formation or word of mouth: What does lagged dependent variable in tourism demand models imply?," Tourism Economics, , vol. 26(3), pages 461-474, May.
    13. Morhaim, Lisa & Ulus, Ayşegül Yıldız, 2023. "On history-dependent optimization models: A unified framework to analyze models with habits, satiation and optimal growth," Journal of Mathematical Economics, Elsevier, vol. 105(C).
    14. Jorge A. Fornero, 2010. "Ricardian Equivalence Proposition in a NK DSGE Model for two Large Economies: The EU and the US," Working Papers Central Bank of Chile 563, Central Bank of Chile.
    15. Dmitriev, Alexandre & Krznar, Ivo, 2012. "Habit Persistence And International Comovements," Macroeconomic Dynamics, Cambridge University Press, vol. 16(S3), pages 312-330, November.
    16. Li, Minqiang, 2010. "Asset Pricing - A Brief Review," MPRA Paper 22379, University Library of Munich, Germany.
    17. Edward R. Lawrence & John Geppert & Arun J. Prakash, 2009. "An Empirical Investigation of the Campbell-Cochrane Habit Utility Model," Journal of Business Finance & Accounting, Wiley Blackwell, vol. 36(5-6), pages 774-791.
    18. Giuseppe Cappelletti, 2012. "Do wealth fluctuations generate time-varying risk aversion? Italian micro-evidence on household asset allocation," Temi di discussione (Economic working papers) 845, Bank of Italy, Economic Research and International Relations Area.
    19. Qiang Dai & Olesya V. Grishchenko, 2014. "An Empirical Investigation of Consumption-Based Asset Pricing Models with Stochastic Habit Formation," Quarterly Journal of Finance (QJF), World Scientific Publishing Co. Pte. Ltd., vol. 4(01), pages 1-34.
    20. James P. Cover & Boyi Zhuang, 2021. "Life with habit and expectation: A new explanation of equity premium puzzle," Economic Notes, Banca Monte dei Paschi di Siena SpA, vol. 50(1), February.

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