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doi:10.1006/redy.1998.0035 
Copyright © 2000 Academic Press All rights reserved.
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Received 18 September 1997.
Abstract
Many asset pricing puzzles can be explained when habit formation is added to standard preferences. We show that utility functions with a habit then gives rise to a puzzle of consumption volatility in place of the asset pricing puzzles when agents can choose consumption and labor optimally in response to more fundamental shocks. We show that the consumption reaction to technology shocks is too small by an order of magnitude when a utility includes a consumption habit. Moreover, once a habit in leisure is included, labor input is counterfactually smooth over the cycle. In the case of habits in both consumption and leisure, labor input is even countercyclical. Consumption continues to be too smooth. Journal of Economic Literature Classification Numbers: E13, E21, E32.
Keywords: habit formation; real business cycles; consumption
We thank John Campbell, an anonymous referee, and the participants of seminars at Maastricht, Mannheim, Tilburg, the CEPR summer symposium in finance 1996, and the AEA 1996 meetings for helpful comments. The views expressed in this paper are those of the authors and are not necessarily those of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors and omissions are the responsibility of the authors.
f1 Martin.Lettau@ny.frb.org
f2 uhlig@kub.nl
