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Consumption Commitments and Habit Formation

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  • Raj Chetty
  • Adam Szeidl

Abstract

We analyze the implications of household-level adjustment costs for the dynamics of aggregate consumption. We show that an economy in which agents have “consumption commitments” is approximately equivalent to a habit formation model in which the habit stock is a weighted average of past consumption if idiosyncratic risk is large relative to aggregate risk. Consumption commitments can thus explain the empirical regularity that consumption is excessively sensitive and excessively smooth, findings that are typically attributed to habit formation. Unlike habit formation and other theories, but consistent with empirical evidence, the consumption commitments model also predicts that excess sensitivity and smoothness vanish for large shocks. These results suggest that behavior previously attributed to habit formation may be better explained by adjustment costs. We develop additional testable predictions to further distinguish the commitment and habit models and show that the two models have different welfare implications.

Suggested Citation

  • Raj Chetty & Adam Szeidl, 2004. "Consumption Commitments and Habit Formation," NBER Working Papers 10970, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:10970
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    Cited by:

    1. Christopher D. Carroll & Johns Hopkins University, 2006. "Sticky Expectations and Consumption Dynamics," Computing in Economics and Finance 2006 21, Society for Computational 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. Hussain, Syed M. & Malik, Samreen, 2016. "Asymmetric Effects of Exogenous Tax Changes," Journal of Economic Dynamics and Control, Elsevier, vol. 69(C), pages 268-300.
    4. 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.
    5. 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.).
    6. Andrew Benito, 2007. "Housing equity as a buffer: evidence from UK households," Bank of England working papers 324, Bank of England.

    More about this item

    JEL classification:

    • D8 - Microeconomics - - Information, Knowledge, and Uncertainty
    • E21 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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