# Duesenberry's Theory of Consumption: Habit, Learning, and Ratcheting

## TL;DR

This paper models consumption and investment decisions considering habit formation and irreversibility, revealing dynamic thresholds and risk behaviors that explain key puzzles in asset pricing and household finance.

## Contribution

It formalizes Duesenberry's theory with a novel (s, S) policy framework, capturing consumption habits and risk-taking dynamics in a unified model.

## Key findings

- Optimal policies feature two wealth thresholds with constant consumption within them.
- Risky investment share is inverse U-shaped within the (s, S) band, causing time-varying risk aversion.
- Model explains smooth consumption, high equity premium, and volatility in asset returns.

## Abstract

This paper investigates the consumption and risk taking decision of an economic agent with partial irreversibility of consumption decision by formalizing the theory proposed by Duesenberry (1949). The optimal policies exhibit a type of the (s, S) policy: there are two wealth thresholds within which consumption stays constant. Consumption increases or decreases at the thresholds and after the adjustment new thresholds are set. The share of risky investment in the agent's total investment is inversely U-shaped within the (s, S) band, which generates time-varying risk aversion that can fluctuate widely over time. This property can explain puzzles and questions on asset pricing and households' portfolio choices, e.g., why aggregate consumption is so smooth whereas the high equity premium is high and the equity return has high volatility, why the risky share is so low whereas the estimated risk aversion by the micro-level data is small, and whether and when an increase in wealth has an impact on the risky share. Also, the partial irreversibility model can explain both the excess sensitivity and the excess smoothness of consumption.