Habit persistence, asset returns and the business cycles

We introduce two modifications into the standard real business cycles model: habit persistence preferences and limitations on intersectoral mobility. The resulting model is consistent with the observed mean equity premium, mean risk free rate and Sharpe ration on equity. With respect to the conventional measures of business cycle volatility and comovement, the model does roughly as well as the standard real business cycle model. On four other dimensions its business cycle implications represent a substantial improvement. It accounts for (i) persistence in output, (ii) the observation that employment across different sectors moves together over the business cycle, (iii) the evidence of 'excess sensitivity' of consumption growth to output growth, and (iv) the 'the inverted leading indicator property of interest rates,' that high interest rates are negatively correlated with future output.