[2018-4] Changes in Habit Formation in Consumption and Implications

habit formation consumption economic effects fluctuations household debt
Research Department(02-759-4254)

The post-crisis rate of growth in household consumption has shown
movements different from those during the pre-crisis period. The rate has
fluctuated within a narrower range but more frequently than before, and
its average has almost halved. This paper uses the concept of habit
formation in consumption to analyze what has caused these changes in
household consumption, and examines the economic effects of changes in
habit formation.

In the household utility function, habit formation in consumption
reflects how previous consumption affects household utility. In other
words, habit formation is a parameter connecting household utility to
previous consumption in the household utility function, and is closely
related with the persistence of consumption. Empirically, habit formation
in consumption can be estimated by using time series to calculate the
sum of autoregressive coefficients of the consumption growth rate. With
other factors remaining unchanged, weaker habit formation in
consumption (i.e. a smaller impact of previous consumption) is associated
with greater fluctuations of the consumption growth rate as well as a
lower average rate. A similar pattern has been witnessed since the crisis.
The estimate of Korea’s habit formation in consumption generally
exceeded 0.5 from 2001 to 2007, but the figure declined to below zero
after the crisis, from 2010 to 2016. This decline in the estimate seems to
have resulted from the weakened relationship between income and
consumption, and also from the increased debt burden following the
buildup of household debt since the crisis.


Next, this paper uses a small open economy DSGE model to examine
changes in impulse responses to a weakening of habit formation. In the
event of internal or external shocks, the responses of the consumption
and GDP growth rates are greater in the initial stage, and the subsequent
disappearing of such responses is faster, in economies with weak habit
formation than in those with strong habit formation. This suggests that a
series of various shocks may lead to huge economic fluctuations in
economies with weak habit formation.

Overall, unexpected economic shocks may cause rapid changes in
economic variables in a situation like the recent period when there is weak
habit formation and the economy shows a modest recovery. It is therefore
all the more important to monitor internal and external shocks, and work
to stabilize the economy when economic shocks are expected to have
excessive spillover effects. Furthermore, in order to strengthen the domestic
demand base through consumption, it will be necessary to not only
increase income but also promote its stability and gradually reduce the
household debt burden.


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