Can Habit Formation be Reconciled with Business Cycle Facts?

Abstract

Many asset pricing puzzles can be explained when habit formation is added to standard preferences. We show that utility functions with a habit then gives rise to a puzzle of consumption volatility in place of the asset pricing puzzles when agents can choose consumption and labor optimally in response to more fundamental shocks. We show that the consumption reaction to technology shocks are too small by an order of magnitude when a utility includes a habit. Alternative models with consistent and exogenous but stochastic labor input are considered. A model with persistent technology shocks and stochastic labor is shown to be potentially consistent with substantial consumption variability aswell as procyclical labor input and labor productivity even when a habit is present.