Can Habit Formation Be Reconciled with Business Cycle Facts?

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. Q 2000 Academic Press