Habit Formation

Abel1990AER
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This paper introduces a utility function that nests three classes of utility functions: 1) time-separable utility functions; 2) "catching up with the Joneses" utility functions that depend on the consumer's level of consumption relative to the lagged cross-sectional average level of consumption; and 3) utility functions that display habit formation. Incorporating this utility function into a Lucas (1978) asset pricing model allows calculation of closed-form solutions for the prices of stocks, bills and consols under the assumption that consumption growth is i.i.d. Then equilibrium asset prices are used to examine the equity premium puzzle.

Panel C presents the unconditional expected rates of return under habit formation. The expected rates of return on both long-lived assets (stocks and consols) are extremely sensitive to the value of ALPHA (coefficient of risk averesion). Under logarithmic utility (ALPHA = 1), the expected rates of return are the same as under time-separable preferences and relative consumption. However, with ALPHA = 1.14, the expected rates of return on stocks and consols are both greater than 35 percent.
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