FIN-01-024

Habit Formation and Returns on Bonds and Stocks

Revised, May 2002

Jessica A. Wachter

ABSTRACT

This paper proposes a habit formation model that explains the failure of the expectations hypothesis documented by Campbell and Shiller (1991) and Fama and Bliss (1987). The model also produces positive excess returns on long-term bonds, an upward sloping average yield curve, and allows for realistic levels of time-variation in the mean of consumption growth. The model generates a novel empirical prediction: Long lags of consumption growth predict the short-term interest rate with a negative sign. This prediction is shown to be strongly supported by the data.


Jessica A. Wachter
Institution: Stern School of Business, New York University, 44th West 4th Street, New York, NY 10012
Telephone: (212) 998-0799
Fax: 212) 995-4233
Email: jwachter@stern.nyu.edu
Homepage:http://www.stern.nyu.edu/~jwachter/

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