Do the "Joneses" Really Matter? Peer-group vs. Correlated Effects in Consumption

Recent theoretical contributions have suggested consumption externalities or external habit formation as a potential explanation for some of the puzzles documented in the literature on finance and consumption. Furthermore, social interactions or peer-group effects are likely to be an important determinant of individual utility derived from consumption. However, the empirical relevance of these phenomena is still largely an open question. We investigate whether there is evidence for external habit formation in preferences using US panel data from the PSID. Specifically, we focus on a "keeping up with the Joneses" specification of individual utility as a framework to assess the possible impact of current peer group consumption on the optimal intertemporal consumption allocation of similar households. The analysis is complicated by the observational equivalence between actual endogenous effects and (both observable and unobservable) correlated effects. To tackle this issue, we propose a set of demographic controls as well as a transformation of the linearized Euler equation along the lines of the "reflection problem" framework of Manski (1993). Our main finding is that once correlated effects are appropriately accounted for, the evidence for peer-group effects vanishes. Specifically, we cannot reject the null hypothesis of no external habit formation. ∗Ph.D. Students, European University Institute, Department of Economics, Via della Piazzuola 43, 50133 Firenze, Italia. Email: [email protected] and [email protected] respectively. We would like to thank Giuseppe Bertola, Charles Grant, Roger Klein and Frank Vella for helpful discussion. Needless to say, all errors our solely our own responsibility.