Pijoan-Mas, Josep; (2002) The role of habit formation in general equilibrium macroeconomics. Doctoral thesis (Ph.D), UCL (University College London).

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Abstract

This Ph.D. thesis consists of two contributed papers. It builds on the recent dynamic macroeconomic literature on heterogeneous agents economies. Using the standard neoclassical growth model with infinitely lived agents facing incomplete insurance markets and idiosyncratic uncertainty, I study the consequences of their consumption-savings decisions for precautionary savings, wealth inequality and asset pricing when habit formation preferences are introduced. In the first paper I examine the role of habit formation in shaping the wealth distribution in an otherwise standard heterogeneous agents model economy with idiosyncratic uncertainty. I compare the implications for precautionary savings and for wealth concentration between economies that only differ in the role played by habit formation. I find that habit formation brings a hefty increase in precautionary savings and very mild reductions in the statistics of wealth inequality. The second paper extends the class of models that support the habits explanation for the equity premium puzzle in order to account for heterogeneity in earnings, wealth, habits and consumption. I find that, contrary to the earlier results in the literature, the presence of habits does not imply a price for risk much higher than the one implied by models with intertemporally separable preferences. The main reasons for this are general equilibrium ones. Firstly, with just two assets available, households can smooth out consumption fluctuations very well. Therefore, the higher utility losses of uncertainty imposed by habits will not command a high price of risk because households manage to avoid this risk. Secondly, the composition of the set of agents pricing the assets is sensitive to changes in the model. In an economy with habits, pricing agents turn out to be households facing very small consumption fluctuations. The model is extended to account for firms financing their capital through bonds. The qualitative results remain unchanged.

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