Habit Formation Heterogeneity: Implications for Aggregate Asset Pricing

We explicitly solve for aggregate asset prices in a discrete-time general- equilibrium endowment economy with two agents who differ with respect to their preferences for risk aversion and sensitivity to additive habit, either internal or external. We generalize an algorithm of Dumas and Lyasoff (2012) for the case of utility functions with time nonseparability that is induced by habit preferences. In the internal habit case, we find that the equilibrium equity premium, equity return volatility, Sharpe ratio, and risk-free rate and its volatility are more consistent with historically observed aggregate prices relative to the external habit case (“catching up with the Joneses”).