Business Cycle Implications of Habit Formation

Abstract

The inability of a wide array of dynamic stochastic general equilibrium (DSGE) models to generate fluctuations that resemble actual business cycles has lead to the use of habit formation in consumption. For example, habit formation has been shown to help explain the negative response of labour input to a positive, permanent technology shock, several asset pricing puzzles, and the impact of monetary shocks on real variables. Investigating four different DSGE models with the Bayesian calibration approach, this paper observes that, especially in a new Keynesian monetary business cycle model with both staggered price and wage, habit formation fails to mimic the shape of output growth in the frequency domain: it counterfactually emphasizes low frequency fluctuations in output growth, compared to the U.S. data. On the other hand, habit formation has no clear implications on other business cycle aspects including impulse responses and forecast error variance decompositions of output to permanent and transitory shocks. These observations cast doubt on habit formation as an important ingredient of the DSGE model with a rich set of internal propagation mechanisms.Business Cycle; Habit Formation; Frequency Domain; Bayesian Calibration