Consumption, Habit Formation and Precautionary Saving: Evidence from the British Household Panel Survey

In this paper, we generalise Weil's (1993) model, which is based on hybrid non‐expected utility preferences, by allowing for habit formation. We use this generalised model to derive an Euler equation, where current consumption changes depend on lagged changes and labour income risk. We then estimate this Euler equation using data from the British Household Panel Survey (BHPS) for the period 1992–97. Our results suggest that both labour income risk and past changes in consumption play an important role in determining current changes in consumption. We then compare the model with habits with the one without, and strongly reject the latter.