Risky Habits: On Risk Sharing, Habit Formation, and the Interpretation of International Consumption Correlations

Jeffrey C. Fuhrer () and Michael W. Klein ()

No 6735, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: Standard international economic models with life cycle/permanent income consumption behavior predict that international portfolio diversification leads to high bilateral consumption correlations. Thus international consumption correlations have been empirically estimated as a test of international portfolio diversification and risk sharing. In this paper we investigate the international consumption correlations generated by a more general model which incorporates habit formation in consumption. We show that, in the presence of common interest rate movements, habit formation itself can generate positive international consumption correlations even in the absence of any international risk sharing. Empirical evidence presented in this paper suggests habit formation characterizes consumption behavior among most of the G-7 countries. Thus, the extent of international portfolio diversification may be even lower than that suggested by previous research which studied international consumption correlations.

JEL-codes: F36 F41 (search for similar items in EconPapers)
Date: 1998-09
Note: IFM
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Journal Article: Risky Habits: on Risk Sharing, Habit Formation, and the Interpretation of International Consumption Correlations (2006)
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