External habit: Anything goes

Pohl, Walter Edward (2016). External habit: Anything goes. Economics Letters, 146:140-142.

Abstract

This paper explores the expressive ability of the external habit mechanism. I show that whenever the stochastic discount factor (SDF) is a function of aggregate consumption, there exists a representative agent external habit model that replicates that SDF. I also show that within this framework the other utility function parameters become indeterminate, in that a different choice of power utility can lead to the exact same SDF. The indeterminacy arises from an ambiguity in the SDF between the externality and individual consumption.

Abstract

This paper explores the expressive ability of the external habit mechanism. I show that whenever the stochastic discount factor (SDF) is a function of aggregate consumption, there exists a representative agent external habit model that replicates that SDF. I also show that within this framework the other utility function parameters become indeterminate, in that a different choice of power utility can lead to the exact same SDF. The indeterminacy arises from an ambiguity in the SDF between the externality and individual consumption.

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