By Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior / John Y. Campbell, John H. Cochrane.

Format:

Book

Author/Creator:

Campbell, John Y.

Contributor:

National Bureau of Economic Research.

Cochrane, John H.

Series:

Working Paper Series (National Bureau of Economic Research) no. w4995.

NBER working paper series no. w4995

Language:

English

Subjects (All):

Consumption (Economics).

Capital assets pricing model.

Stock price forecasting.

Rate of return.

Physical Description:

1 online resource: illustrations (black and white);

Other Title:

By Force of Habit

Place of Publication:

Cambridge, Mass. National Bureau of Economic Research 1995.

Cambridge, Massachusetts : National Bureau of Economic Research, 1995.

Summary:

We present a consumption-based model that explains the procyclical variation of stock prices, the long-horizon predictability of excess stock returns, and the countercyclical variation of stock market volatility. Our model has an i.i.d. consumption growth driving process, and adds a slow-moving external habit to the standard power utility function. The latter feature produces cyclical variation in risk aversion, and hence in the prices of risky assets. Our model also predicts many of the difficulties that beset the standard power utility model, including Euler equation rejections, no correlation between mean consumption growth and interest rates, very high estimates of risk aversion, and pricing errors that are larger than those of the static CAPM. Our model captures much of the history of stock prices, given only consumption data. Since our model captures the equity premium, it implies that fluctuations have important welfare costs. Unlike many habit-persistence models, our model does not necessarily produce cyclical variation in the risk free interest rate, nor does it produce an extremely skewed distribution or negative realizations of the marginal rate of substitution.

Notes:

Print version record

January 1995.