Endogenous Habits and Equilibrium Asset Prices

Abstract

We study a two-agent equilibrium model with two goods where we interpret the agents as countries. We analyze the effect of an endogenous habit specification where each country benchmarks its consumption decision against the decision of the other country. We show that endogenous habits can generate high equity premia and low interest rates. Our framework allows to study setups where agents cooperate or do not cooperate. The optimality conditions of the non-cooperative setting are similar to models that consider agents with exogenous habit levels. Although the size of the equity premia and the risk-free rate are of the same order of magnitude in both settings, the consumption allocations are more even in the cooperative situation.