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Consumption Commitments and Habit Formation

  • Raj Chetty
  • Adam Szeidl

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 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 despite generating similar aggregate consumption patterns in many environments.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 10970.

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Date of creation: Dec 2004
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Handle: RePEc:nbr:nberwo:10970
Note: EFG PE
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