Keeping Up with the Joneses: Evidence from Micro Data

Abstract

This paper provides evidence that habit persistence is an important determinant of household consumption choices in a setting that allows for individual heterogeneity and credit constraints. By using actual individual consumption data, I find that the strength of the external habit, captured by the consumption of the reference group, is 0.290; while the strength of internal habit, represented by household past consumption, is 0.503. These findings provide empirical support to the theories that explain the equity premium puzzle by introducing habit persistence in the utility function. The results are robust to the inclusion of income growth rate and other measures of economic activity in the regression, changes in specification and in the instrument set. I also show that my specification subsumes the isoelastic specification used in Constantinides (1990), Abel (1990) and Campbell and Cochrane (1999) and that the strength of habit, the curvature of the utility function and the coefficient of relative risk aversion are similar to theirs. Finally, I show how incorrect aggregation and neglecting heterogeneity can explain why empirical studies of habit persistence based on aggregate consumption data and a representative agent reach mixed or negative findings.

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