External Habit in a Production Economy

Chen, Andrew Y.

External Habit in a Production Economy

Andrew Y. Chen
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Andrew Y. Chen: OH State University

Working Paper Series from Ohio State University, Charles A. Dice Center for Research in Financial Economics

Abstract: A unified framework for understanding asset prices and aggregate fluctuations is critical for understanding both issues. I show that a real business cycle model with external habit preferences and capital adjustment costs provides one such framework. The estimated model matches the first two moments of the equity premium and risk-free rate, return and dividend predictability regressions, and the second moments of output, consumption, and investment. The model also endogenizes a key mechanism of consumption-based asset pricing models. In order to address the Shiller volatility puzzle, external habit, long-run risk, and disaster models require the assumption that the volatility of marginal utility is countercyclical. In the model, this countercyclical volatility arises endogenously. Production makes precautionary savings effects show up in consumption. These effects lead to countercyclical consumption volatility and countercyclical volatility of marginal utility. External habit amplifies this channel and makes it quantitatively significant.

JEL-codes: E21 E30 G12 (search for similar items in EconPapers)
Date: 2013-10
New Economics Papers: this item is included in nep-dge, nep-mac and nep-upt
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Persistent link: https://EconPapers.repec.org/RePEc:ecl:ohidic:2013-16

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