Intertemporally Dependent Preferences and the Volatility of Consumption and Wealth

Abstract

In this article we construct a model in which a consumer's utility depends on the consumption history We describe a general equilibrium framework similar to Cox, Ingersoll, and Ross (1985a). A simple example is then solved in closedform in this general equilibrium setting to rationalize the observed stickiness of the consumption series relative to the fluctuations in stock market wealth. The sample paths of consumption generated from this model imply lower variability in consumption growth rates compared to those generated by models with separable utilizations. We then present a partial equilibrium model similar to Merton (1969Merton ( , 1971) and extend Merton's results on optimal consumption and portfolio rules to accommodate nonseparability in preferences. Asset pricing implications of our framework are briefly explored.The idea that a given bundle of consumption goods will provide the same level of satisfaction at any date regardless of one's past consumption experience is implicit in models that use time-separable utility functions to represent preferences. Separable utility functions have been the mainstay in much of the literature on asset pricing and optimal consumption and portfolioThe results reported in this article were first presented at the EFA meetings in Bern, Switzerland, in 1985 [see Sundaresan (1984]. Subsequently the article was presented at a number of universities and conferences. I thank the participants at those presentations for their feedback. I am especially thankful to Doug Breeden, Michael Brennan, John Cox, Chi-fu Huang, and Krishna Ramaswamy for their thoughtful comments and criticisms. I also thank Tong-sheng Sun for explaining the simulation procedure for stochastic differential equations and for his comments and suggestions. I am responsible for any remaining errors.

Asset and commodity prices with multi-attribute durable goods

“…implications with observed empirical regularities have mainly focussed on the structure of preferences. To this end recursive preferences (Epstein and Zin (1989), Duffie and Epstein (1992)), preferences embodying substitutability of consumptions at different dates Huang (1992,1993)) and habit forming preferences (Abel (1989), Sundaresan (1989), Constantinides (1990), Zapatero (1991, 1992) and Heaton (1993)) have been investigated. Models based on habit forming 3 preferences, for instance, may produce low volatility of consumption since habits increase the cost of current consumption; they may also increase the magnitude of asset risk premia as a result of "increased risk aversion".…”

Nonlinearity and Flight to Safety in the Risk-Return Trade-Off for Stocks and Bonds

“…In habit formation theories, utility depends not just on the level of current consumption, but rather on current consumption in excess of previously experienced consumption. Asset pricing implications of habit formation were pioneered by Abel (1990), Constantinides (1990), and Sundaresan (1989). Our discussion will focus on the theory by Cochrane (1999, 2000), which has synthesized earlier work, and proven successful in explaining asset pricing puzzles.…”

Consumption habits and humps

“…Habit features in preferences have proven helpful in explaining stylized asset pricing facts that seem puzzling when agents are assumed to have time-separable power utility, see, e.g., Sundaresan (1989), Abel (1990), Constantinides (1990), Campbell and Cochrane (1999), and Menzly, Santos, and Veronesi (2004). Based on an endowment economy with identical agents, Grischenko (2010) concludes that an internal habit specification provides a better match with asset pricing data than an external habit specification.…”