Habit Formation and Keeping Up with the Joneses

Book excerpt: This paper provides evidence of habit persistence in household consumption choices. I find that the strength of external habit, captured by the fraction of the consumption of the reference group that enters the utility function, is 0.290, and the strength of internal habit, represented by household past consumption, is 0.503. The results are robust to controlling for various measures of economic activity, tests for the presence of aggregate shocks, liquidity constraints, precautionary saving motives, and learning. Aggregation of the Euler equations as a weighted average of individual marginal rates of substitution accounts for heterogeneity and market incompleteness and preserves the results.