Deep Habits: Macroeconomic and Asset Pricing Implications

Master Thesis by Yu, Li
July 26, 2005

Abstract:

Motivated by the idea of Ravn, Schmitt-Grohé and Uribe (2005), the deep habits models are developed in this paper. Under deep habits, households do not simply form habits from their overall consumption levels, but rather feel the need to catch up with Joneses on a good-by-good basis. This assumption alters not only the demand side, but also the supply side of the economy, which allows the models have more abundant implications on both asset market and business cycle properties.

Our empirical studies on the stylized facts of asset prices, business cycle facts and in particular the countercyclical markup evidence serve as the bases of our analysis. To explore the asset pricing implications of the model, we derive the explicit solutions of important financial variables based on the log-linearization of the models. Thus, the determinative factors of the Sharpe ratio can be expressed by the deep parameters, and in turn the Sharpe ratio can be numerically analyzed. On the other hand, the dynamics of markup are discussed with three important effects. Allowing more realistic assumption, we add the deep habits into a Calvo-type sticky price model, where both the price stickiness and deep habits affect the markup behavior.

Being consistent with the literature, our discussions show that deep habits contribute to the countercyclical markup under both flexible and sticky price frameworks; adding habit formation and capital adjustment cost can help generate sizeable Sharpe ratio; the nonseparability between consumption and leisure can help explain the premium puzzles within certain scope. Moreover, when combining the deep habit with a preference nonseparable in consumption and leisure, the problems, such as negative labor response of most capital adjustment cost models, will disappear. In turn, it allows to explain the comovement in output, consumption, investment and labor.