Habit Formation Effect On Households Consumption In China: Investigation Using Dynamic Panel Data Model

In the past two decades, many studies have used household panel data on consumption to examine behavior when preferences are assumed to be time nonseparable. The paper focuses on a specific class of time nonseparable preferences:those exhibiting habit formation. With habit formation, current utility depends not only on current expenditures, but also on a "habit stock" formed by lagged expenditures. For a given level of current expenditure, a larger habit stock lowers utility.One of the most common approaches in micro-econometric studies used to test the presence of habit formation has been the Euler equation approach. It focuses on a specific first-order condition implied by the optimization problem faced by a generic consumer, allowing the estimation of preference parameters. An alternative approach to the Euler equation is adopted by Alessie and Lusardi(1997), who derive closed-form solutions for consumption under the assumption of CARA within period preferences. In this paper, we estimate the model of Alessie and Lusardi(1997). Our empirical model is based on their closed-form solutions, where consumption is expressed as a function of lagged consumption and other regressors. We opt for this choice because the closed form solution embodies more information about the habit formation model than the Euler equation does.This paper tests for the presence of habit formation using rural and urban household data from the China Health and Nutrition Survey from 1989 through 2006. By conducting the system GMM estimations, we find strong evidence of habit formation on nondurables consumption. The habit formation effect is important in explaining the high saving rates of rural and urban households in China. This finding is robust when considering the precautionary saving motivation of rural and urban household. In our study, the marginal effect of habit formation on consumption is much larger than that of precautionary motivation, and the magnitude of the habit formation coefficient in urban households food consumption is smaller than its rural counterpart. Moreover, We find that household wealth is positively related to the strength of habit formation effect. The richer a household is, the larger habit formation coefficient becomes. In this sense, It is evident that income disparity is one of the causes of the high saving rates of households in China.