Consumption Commitments: A Foundation for Reference-Dependent Preferences and Habit Formation

We build a theory of reference-dependent preferences based on adjustment costs in consumption. The main contribution of the theory is that it endogenizes the evolution of the reference point. The reference point generated by our model exhibits several features exogenously assumed in existing theories: it (1) re‡ects recent expectations, (2) depends on past consumption levels, and (3) diminishes in importance when agents experience large shocks. When the ratio of idiosyncratic to aggregate risk is large, the model is approximately equivalent to standard habit formation speci…cations in which the reference point is a weighted average of past consumption. We illustrate the implications of endogenizing the reference point using three applications: aggregate consumption dynamics, changes in policy parameters, and the welfare cost of shocks. In each application, our model of endogenous reference points con…rms certain intuitions from existing theories but yields some starkly di¤erent predictions. For example, reducing idiosyncratic risk can raise the welfare cost of aggregate shocks by making reference points more persistent. E-mail addresses: [email protected] and [email protected]. We thank John Campbell, Gary Chamberlain, Tom Davido¤, Drew Fudenberg, Elhanan Helpman, Miklos Koren, Hanno Lustig, Todd Sinai, Jeremy Stein, and Moto Yogo for comments. We are grateful for funding from the National Science Foundation Grant SES 0522073, the Social Science Research Council, and the Institute for Humane Studies.