External Habit in a Production Economy: A Model of Asset Prices and Consumption Volatility Risk

Andrew Y. Chen

The Review of Financial Studies, 2017, vol. 30, issue 8, 2890-2932

Abstract: A standard real business-cycle model with external habit and capital adjustment costs matches a long list of asset price and business-cycle moments: equity, firm value, and risk-free rate volatility; the equity premium; excess return predictability; consumption growth predictability; basic moments of consumption, output, and investment; among others. The model also generates endogenous consumption volatility risk. Precautionary savings motives make consumption sensitive to shocks in bad times, leading to countercyclical volatility, even with homoscedastic technology shocks. Habit acts as countercyclical leverage, which amplifies this channel. Habit also implies high risk aversion, which amplifies the stock price response.Received April 21, 2016; editorial decision February 3, 2017 by Editor Stijn Van Nieuwerburgh.

JEL-codes: E21 E30 G21 (search for similar items in EconPapers)
Date: 2017
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