Habit Formation with Nonseparability between Consumption and Leisure

Diploma Thesis by Martin Kliem
February 19, 2004

Abstract:

Habit formation has had some success in replicating some of the historical financial data. Furthermore, habit formation brings difficulties to the simultanous study of both financial markets and business cycles. This thesis reviews the performance of habit formation and presents an external habit with nonseparability between consumption and leisure. The asset pricing implications obtained, as well as the ability to match main business cycle facts, will be presented and compared with other preferences.

This thesis contains an analysis of historicsl data from the past thirty-eight years, wherein the co-movement between leisure, consumption, and the stock market were measured. This analysis shows some key problems of consumption-based asset pricing literature, e.g., an intensified volatility puzzle, as well as changes over the last decades that have an impact on the asset pricing literature.

The counterfactuality of nonseparability between consumption and leisure for asset pricing will be shown, as well as the poor performance of habit formation as a whole. Moreover, the advantages of nonseparablility in matching business cycle facts will be shown. The model provided overcomes the smoothness of consumption as well as the non-volatility of leisure, whereby these results can be obtained by introducing capital adjustment costs. Finally, the difficulties with this and the possible counterfactuality of leisure responses will be discussed.