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Does habit formation always increase the agents' desire to smooth consumption?

  • Emmanuelle Augeraud-Veron
  • Mauro Bambi

In the literature, habit formation has been often introduced to enhance the agents' desire to smooth consumption over time. This characteristic was found particularly useful in solving the equity premium puzzle and in matching several stylized facts in growth, and business cycles theory as, for example, the high persistence in the U.S. output volatility. In this paper we propose a definition of habit formation, which is ``general'' relative to the assumptions on the intensity, persistence, and lag structure, and we unveil two mechanisms which point to the opposite direction: habits may reduce the desire of smoothing consumption over time and then may potentially decrease the power of a model in explaining the previously mentioned facts. More precisely, we propose a complete taxonomy of the rich dynamics which may emerge in an AK model with external addictive habits for all the feasible combinations of the intensity, persistence and lag structure characterizing their formation and we point out to the region in the parameters' space coherent with less smoothing in consumption. An economic explanation of these mechanisms is suggested and the robustness of our results in the case of internal habits verified. Finally and crucially habit formation always reduces the desire of consumption smoothing once the model is calibrated to match the average U.S. output and utility growth rates observed in the data.

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Paper provided by Department of Economics, University of York in its series Discussion Papers with number 12/12.

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Date of creation: Apr 2012
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Handle: RePEc:yor:yorken:12/12
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  1. Jaime Alonso-Carrera & Jordi Caballé & Xavier Raurich, 2005. "Estate Taxes, Consumption Externalities, and Altruism," UFAE and IAE Working Papers 658.05, Unitat de Fonaments de l'Anàlisi Econòmica (UAB) and Institut d'Anàlisi Econòmica (CSIC).
  2. Francisco Alvarez-Cuadrado & Goncalo Monteiro & Stephen J. Turnovsky, 2004. "Habit Formation, Catching Up with the Joneses, and Economic Growth," Journal of Economic Growth, Springer, vol. 9(1), pages 47-80, 03.
  3. Cochrane, John H. & Campbell, John, 1999. "By Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior," Scholarly Articles 3119444, Harvard University Department of Economics.
  4. Cooper, B. & Garcia-Penalosa, C., 1998. "Status Effects and Neganive Utility Growth," Economics Papers 150, Economics Group, Nuffield College, University of Oxford.
  5. Raouf BOUCEKKINE & Omar LICANDRO & Luis A. PUCH & Fernando DEL RIO, 2002. "Vintage Capital And the Dynamics of the AK Model," Economics Working Papers ECO2002/07, European University Institute.
  6. Ravn, Morten O & Schmitt-Grohé, Stephanie & Uribe, Martín, 2004. "Deep Habits," CEPR Discussion Papers 4269, C.E.P.R. Discussion Papers.
  7. Fabbri, Giorgio & Gozzi, Fausto, 2008. "Solving optimal growth models with vintage capital: The dynamic programming approach," Journal of Economic Theory, Elsevier, vol. 143(1), pages 331-373, November.
  8. Jaime Alonso-Carrera & Jordi Caballe & Xavier Raurich, 2004. "Aspirations, Habit Formation, and Bequest Motive," Working Papers 136, Barcelona Graduate School of Economics.
  9. Alonso-Carrera, Jaime & Caballe, Jordi & Raurich, Xavier, 2005. "Growth, habit formation, and catching-up with the Joneses," European Economic Review, Elsevier, vol. 49(6), pages 1665-1691, August.
  10. Bambi, Mauro & Fabbri, Giorgio & Gozzi, Fausto, 2009. "Optimal policy and consumption smoothing effects in the time-to-build AK model," MPRA Paper 17128, University Library of Munich, Germany.
  11. Kareen Rozen, 2008. "Foundations of Intrinsic Habit Formation," Cowles Foundation Discussion Papers 1642, Cowles Foundation for Research in Economics, Yale University.
  12. Hippolyte d'Albis & Emmanuelle Augeraud-Véron & Hermen Jan Hupkes, 2012. "Discontinuous Initial Value Problems for Functional Differential-Algebraic Equations of Mixed Type," Documents de travail du Centre d'Economie de la Sorbonne 12043, Université Panthéon-Sorbonne (Paris 1), Centre d'Economie de la Sorbonne.
  13. repec:bla:restud:v:77:y:2010:i:4:p:1382-1402 is not listed on IDEAS
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