Testing External Habits in an Asset Pricing Model

The asset pricing model with external habit formation predicts that the equity premium depends on consumption changes relative to the habit level, implying a response that varies over the business cycle. We test this implication using a VAR model of the U.S. postwar economy whose time-varying parameters are estimated conditioning on Markov-switching regimes that shift according to the business cycle phases. This enables us to test whether the non-linear response predicted in the model is significant. The results show that the response of the equity premium to consumption shocks is insignificantly different over the business cycle. We interpret this as evidence against the external habit formation hypothesis.