Business Cycle Dynamics under Catching Up with the Joneses Preferences in Leisure

Master thesis by Thomas Hildebrand
July 21, 2006

Abstract:

In real business cycle models, the concept of habit formation, which can explain phenomena such as the equity premium puzzle, is mostly restricted to the consumption part of the utility function of the representative household. At least, a detailed analysis of the dynamics of a model with habit formation in both consumption and leisure does not yet exist. A priori, there is, however, no reason justifying such a restriction. Thus, this diploma thesis extends standard real business cycle models by introducing the concept of external habit formation (more precisely, so-called catching up with the Joneses preferences) not only into the consumption part, but also into the leisure part of the utility function. Utility depends on leisure but additionally also on some benchmark level which is made up by aggregate average leisure in past periods. We examine the general model dynamics and then concentrate on the implications for consumption- and leisure-choices after a technology shock in such an economy, scrutinizing the corresponding impulseresponses. Our main finding is that introducing habit formation into leisure in a model which already comprises habit formation in consumption smoothes leisure-choices, but only has a very small influence on consumption- choices, let alone the other variables. This may be seen as a justification of the fact that until now, habit formation in leisure has been neglected in economic theory. Several variations of the model (relative rather than absolute consumption and leisure, keeping up with the Joneses preferences rather than catching up with the Joneses preferences, taxes) are considered and analyzed.