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Reexamining the Empirical Relevance of Habit Formation Preferences

  • Cai, Zongwu
  • Liu, Xuan
  • Yang, Fang

We reexamine the empirical relevance of habit formation preferences with micro-data on households' portfolio choices. We first derive the analytical solution to the risky asset share in a theoretical model with both habits and time-varying labor income. Our analytical results indicate that (1) for each household, there are two channels through which the risky asset share responds to wealth fluctuations, habits and household income; (2) across households, there are heterogenous responses through the habit channel: those who experience large negative income shocks reduce their share of risky assets; and (3) two potential mis-identification problems arise when both two channels and the heterogeneity are ignored. Contrary to the existing literature, our empirical results find positive evidence of habit formation preferences after correcting the two mis-identification problems.

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Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 37817.

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Date of creation: 03 Apr 2012
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Handle: RePEc:pra:mprapa:37817
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  1. Michele Boldrin & Lawrence J. Christiano & Jonas D.M. Fisher, 1999. "Habit persistence, asset returns and the business cycles," Working Paper Series WP-99-14, Federal Reserve Bank of Chicago.
  2. Lawrence J. Christiano & Martin Eichenbaum & Charles Evans, 2001. "Nominal rigidities and the dynamic effects of a shock to monetary policy," Proceedings, Federal Reserve Bank of San Francisco, issue Jun.
  3. Jessica A. Wachter & Motohiro Yogo, 2010. "Why Do Household Portfolio Shares Rise in Wealth?," Review of Financial Studies, Society for Financial Studies, vol. 23(11), pages 3929-3965, November.
  4. Markus K. Brunnermeier & Stefan Nagel, 2006. "Do Wealth Fluctuations Generate Time-varying Risk Aversion? Micro-Evidence on Individuals' Asset Allocation," NBER Working Papers 12809, National Bureau of Economic Research, Inc.
  5. 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.
  6. Morten Ravn & Stephanie Schmitt-Grohe & Martin Uribe, 2004. "Deep Habits," NBER Working Papers 10261, National Bureau of Economic Research, Inc.
  7. Samuelson, Paul A, 1969. "Lifetime Portfolio Selection by Dynamic Stochastic Programming," The Review of Economics and Statistics, MIT Press, vol. 51(3), pages 239-46, August.
  8. Karen E. Dynan, 2000. "Habit Formation in Consumer Preferences: Evidence from Panel Data," American Economic Review, American Economic Association, vol. 90(3), pages 391-406, June.
  9. Carrasco, Raquel & Labeaga Azcona, J Maria & López-Salido, J David, 2002. "Consumption and Habits: Evidence from Panel Data," CEPR Discussion Papers 3520, C.E.P.R. Discussion Papers.
  10. Uribe, Martin, 2002. "The price-consumption puzzle of currency pegs," Journal of Monetary Economics, Elsevier, vol. 49(3), pages 533-569, April.
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