TY  - JOUR
AU  - Campbell,John Y.
AU  - Cochrane,John H.
TI  - By Force of Habit: A Consumption-Based Explanation of Aggregate Stock   Market Behavior
JF  - National Bureau of Economic Research Working Paper Series
VL  - No. 4995
PY  - 1995
Y2  - January 1995
UR  - http://www.nber.org/papers/w4995
L1  - http://www.nber.org/papers/w4995.pdf
N1  - Author contact info:
John Y. Campbell
Morton L. and Carole S.
Olshan Professor of Economics
Department of Economics
Harvard University
Littauer Center 213
Cambridge, MA 02138
Tel: 617/496-6448
Fax: 617/495-7730
E-Mail: john_campbell@harvard.edu

John H. Cochrane
Booth School of Business
University of Chicago
5807 S. Woodlawn
Chicago, IL  60637
Tel: 773/702-3059
Fax: 773/702-0458
E-Mail: john.cochrane@chicagobooth.edu
AB  - We present a consumption-based model that explains the procyclical variation of stock prices, the long-horizon predictability of excess stock returns, and the countercyclical variation of stock market volatility.  Our model has an i.i.d. consumption growth driving process, and adds a slow-moving external habit to the standard power utility function.  The latter feature produces cyclical variation in risk aversion, and hence in the prices of risky assets.  Our model also predicts many of the difficulties that beset the standard power utility model, including Euler equation rejections, no correlation between mean consumption growth and interest rates, very high estimates of risk aversion, and pricing errors that are larger than those of the static CAPM.  Our model captures much of the history of stock prices, given only consumption data.  Since our model captures the equity premium, it implies that fluctuations have important welfare costs.  Unlike many habit-persistence models, our model does not necessarily produce cyclical variation in the risk free interest rate, nor does it produce an extremely skewed distribution or negative realizations of the marginal rate of substitution.
ER  -