Habit Formation: A Resolution of the Equity Premium Puzzle

Abstract

The equity premium puzzle, identified by Mehra and Prescott, states that, for plausible values of the risk aversion coefficient, the difference of the expected rate of return on the stock market and the riskless rate of interest is too large, given the observed small variance of the growth rate in per capita consumption. The puzzle is resolved in the context of an economy with rational expectations once the time separability of von Neumann-Morgenstern preferences is relaxed to allow for adjacent complementarity in consumption, a property known as habit persistence. Essentially habit persistence drives a wedge between the relative risk aversion of the representative agent and the intertemporal elasticity of substitution in consumption.