Households’ Consumption under the Habit Formation Hypothesis. Evidence from Italian Households using the Survey of Household Income and Wealth (SHIW)

This paper explores the mis-specification of preferences as a cause of the poor empirical performance of the traditional Life Cycle/Permanent Income model in explaining Italian households’ consumption decisions. Consumption profiles generated under strict life cycle models could be hardly reconciled with those exhibited by Italian households. We estimate how household consumption evolves over time by using an Euler equation approach, enriched both for the presence of habit formation in households’ preferences and uncertainty. We test its performance by using a GMM estimation strategy. Our results prove that ignoring habit persistence can lead to misleading results in interpreting the determinants of consumption.