Habit Persistence, Asset Returns, and the Business Cycle

Two modifications are introduced into the standard real-business-cycle model: habit preferences and a two-sector technology with limited intersectoral factor mobility. The model is consistent with the observed mean risk-free rate, equity premium, and Sharpe ratio on equity. In addition, its business-cycle implications represent a substantial improvement over the standard model. It accounts for persistence in output, comovement of employment across different sectors over the business cycle, the evidence of “excess sensitivity” of consumption growth to output growth, and the “inverted leading-indicator property of interest rates,” that interest rates are negatively correlated with future output. (JEL D10, E10, E20, G12)