Specification tests of habit formation

Abstract

Campbell and Cochrane (1999) propose the habit formation model to explain the equity premium puzzle. They assume that an agent’s consumption is affected by habit and describe how habit adjusts to the history of consumption. We use the simulated moment method to test these two specifications. Empirically, we find that habit plays an important role in an agent’s consumption choice, however not in the way Campbell and Cochrane (1999) specify.

Keywords:

• consumption-based CAPM
• habit formation
• simulated moment method

JEL Classification:

• C13
• G12
• E21

Acknowledgements

Ren’s research was supported by the Fundamental Research Funds for the Central Universities (#2013221022), the Natural Science Foundation of Fujian Province, China (#2011J01384), and the Natural Science Foundation of China (#71301135, #71203189 and #71131008).

Notes

¹ See Campbell and Cochrane (1999), Equation 8.

² Simply, smooth embedment requires function of , economic parameter vector, with respect to , parameter vector to be estimated, to be in a nearby area of the true value of The formal definition can be found in Gallant and Tauchen (1996), Definition 1.

³ In our rudimentary work, we estimated a four-variable VAR(1) system, with interest rate included, and found that the R² of the interest rate equation is about 0.0002.