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Duesenberry's Theory of Consumption: Habit, Learning, and Ratcheting

Kyoung Jin Choi, Junkee Jeon and Hyeng Keun Koo

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Abstract: This paper investigates the consumption and risk taking decision of an economic agent with partial irreversibility of consumption decision by formalizing the theory proposed by Duesenberry (1949). The optimal policies exhibit a type of the (s, S) policy: there are two wealth thresholds within which consumption stays constant. Consumption increases or decreases at the thresholds and after the adjustment new thresholds are set. The share of risky investment in the agent's total investment is inversely U-shaped within the (s, S) band, which generates time-varying risk aversion that can fluctuate widely over time. This property can explain puzzles and questions on asset pricing and households' portfolio choices, e.g., why aggregate consumption is so smooth whereas the high equity premium is high and the equity return has high volatility, why the risky share is so low whereas the estimated risk aversion by the micro-level data is small, and whether and when an increase in wealth has an impact on the risky share. Also, the partial irreversibility model can explain both the excess sensitivity and the excess smoothness of consumption.

New Economics Papers: this item is included in nep-upt
Date: 2018-12
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