Internal vs External Habit Formation: The relative importance for asset pricing

Asset pricing models with habit formation use either "catching up with Joneses" (external habit formation) or "time-nonseparable" (internal habit formation) preference

specifications. In this paper I present a generalized asset pricing model that structurally

nests both types of habit formation.

I derive the asset pricing implications of this model and confront them with the

observed consumption and asset return data to determine the relative importance of

"catching up with Joneses" and internal habit formation. In other words, to what extent

does an individual consumer's preference depend on her own consumption history as

opposed to the aggregate consumption history?

Using long-horizon returns, I show that internal habit formation with a sufficiently

long history of consumption realizations is more consistent with observed asset and bond returns than "catching up with Joneses" preferences. These results have important

implications for researchers attempting to provide microeconomic foundations of habit formation.