Micro-level Estimation of Optimal Consumption Choice with Intertemporal Nonseparability in Preferences and Measurement Errors

This paper investigates the presence of habit formation in household consumption, using data from the Panel Study of Income Dynamics. We develop an econometric model of internal habit formation of the multiplicative specification. The restrictions of the model allow for classical measurement errors in consumption without parametric assumptions on the distribution of measurement errors. We estimate the parameters by nonlinear generalized method of moments and find that habit formation is an important determinant of household food-consumption patterns. Using the parameter estimates, we develop bounds for the expectation of the implied heterogeneous intertemporal elasticity of substitution and relative risk aversion that account for measurement errors, and compute confidence intervals for these bounds.