Enrichetta Ravina

Habit Formation and Keeping Up with the Joneses: Evidence from Micro Data

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Abstract:
This paper provides evidence that habit persistence is an important determinant of household consumption choices, in a setting that allows for heterogeneity and household-specific interest rates. By estimating Euler equations for a representative sample of U.S. credit card account holders, I find that the strength of the external habit, captured by the fraction of the consumption of the reference group that enters the utility function, is 0.290; while the strength of internal habit, represented by household past consumption, is 0.503. These findings provide empirical support to the theories that explain macroeconomic and asset pricing phenomena by introducing habit persistence in the utility function. The results are robust to the inclusion of the income growth rate and other measures of economic activity in the regression, changes in the specification and the instrument set, and tests of liquidity constraints and precautionary saving motives. I also show that this result carries over in the aggregate, once heterogeneity and market incompleteness are taken into account by aggregating the Euler equations as a weighted average of individual marginal rates of substitution. On the contrary, I find that an econometrician that used per capita consumption, constructed from the same data, and a representative agent framework, would find no evidence of habit persistence.

Source: Working Paper
Exact Citation:
Ravina, Enrichetta. "Habit Formation and Keeping Up with the Joneses: Evidence from Micro Data." Working Paper, Columbia Business School, September 2007.
Date: 9 2007