Optimal Endowment Destruction under Campbell-Cochrane Habit Formation

Campbell and Cochrane (1999) formulate a model that successfully explains a wide variety of asset pricing puzzles, by augmenting the standard power utility function with a time-varying subsistence level, or "external habit", that adapts nonlinearly to current and past average consumption in the economy. This paper demonstrates, that this comes at the "price" of several unusual implications. For example, we calculate that a society of agents with the preferences and endowment process of Campbell and Cochrane (1999) would experience a welfare gain equivalent to a permanent increase of nearly 16% in consumption, if the government enforced one month of fasting per year, reducing consumption by 10 percent then. We examine and explain these features of the preferences in detail. We numerically characterize the solution to the social planning problem. We conclude that Campbell-Cochrance preferences will provide for interesting macroeconomic modeling challenges, when endogenizing aggregate consumption choices and government policy.