Can Habit Formation be Reconciled with Business Cycle Facts?

Martin Lettau and Harald Uhlig ()

Review of Economic Dynamics, 2000, vol. 3, issue 1, 79-99

Abstract: Many asset pricing puzzles can be explained when habit formation is added to standard preferences. We show that utility functions with a habit then gives rise to a puzzle of consumption volatility in place of the asset pricing puzzles when agents can choose consumption and labor optimally in response to more fundamental shocks. We show that the consumption reaction to technology shocks are too small by an order of magnitude when a utility includes a consumption habit. Moreover, once a habit in leisure is included, labor input is counterfactually smooth over the cycle. In the case of habit in both consumption and leisure, labor input is even countercyclical. Consumption continues to be too smooth. (Copyright: Elsevier)

Keywords: habit formation; real business cycles; consumption (search for similar items in EconPapers)
JEL-codes: E13 E21 E32 (search for similar items in EconPapers)
Date: 2000
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Citations: View citations in EconPapers (176)

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DOI: 10.1006/redy.1998.0035

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