Non-addictive Habit Formation and the Equity Premium Puzzle

I analyse a model in a simple representative-agent economy with one risky and one riskless asset, populated by habit forming consumer-investors. These consumer-investors exhibit non-addictive habit formation in the sense that the current consumption rate of the consumer-investors can fall below their past habit-forming consumption rate. I endogenise the real riskless rate of return in this representative-agent economy and find that the equity premium puzzle is resolved for plausible values of the coefficient of relative risk aversion, the discount rate, and the intensity of non-addictive habit formation. These values have been validated in previous empirical or survey-based studies. Non-addictive habit-formation studied here complements and extends current research on habit-forming preferences. Given a constant investment opportunity set, the real riskless rate in the economy increases with relative risk aversion of the consumer and decreases as the habit-formation intensity increases. Extensions with time-varying investment opportunity sets could explain the low risk-free rate and the relatively large variability of the market return over the variability of the risk-free rate through time.