Business Intelligence

Asset Prices Under Habit Formation And Catching Up With The Jones

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Executive Summary

This paper introduces a utility function that nests three classes of utility functions: time-separable utility functions; "Catching up with the Joneses" utility functions that depend on the consumer's level of consumption relative to the lagged cross-sectional average level of consumption; and utility functions that display habit formation. Incorporating this utility function into a Lucas (1978) asset pricing model allows calculation of closed-form solutions for the prices of stocks, bills and consols under the assumption that consumption growth is i.i.d. Then equilibrium asset prices are used to examine the equity premium puzzle

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