Macro-Finance Separation by Force of Habit

By J. David Lopez-Salido, Francisco Vazquez-Grande, and Pierlauro Lopez

http://d.repec.org/n?u=RePEc:red:sed015:980&r=dge

We incorporate risk premia variation arising from Campbell-Cochrane habit formation in a standard DSGE framework. We show how the simultaneous presence of consumption and labor habits can produce a separation between quantity and risk premia dynamics, and hence unite nonlinear habits and a production economy without compromising the ability of the model to fit macroeconomic variables. We can then use economic theory rather than a reduced-form approach to restrict several cashflow processes endogenously and study their pricing. First, nominal price rigidities explain an endogenous difference between aggregate consumption and market dividends and between real and nominal bonds that can rationalize two major asset pricing puzzles – an initially downward-sloping term structure of equity and an upward-sloping term structure of interest rates. Second, the model is able to explain the capital market’s reaction to a monetary policy shock documented by the extant literature.

Very nice paper that shows that accounting for habit formation, once more, can go a very long way in explaining the data. Time for this to become more frequently used in the literature.