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This paper develops a general equilibrium model for a representative agent, production economy with stochastic internal habit formation. The model describes a scale-independent economy, with a unique stochastic investment opportunity set. Local correlation between the stochastic interest rate and time-varying market price of risk can be determined endogenously and leads to correct predictions on the sign and magnitude of several major empirical puzzles in both equity and bond markets. In the empirical part of the paper, we calibrate our model, simultaneously, to the equity premium puzzle, the risk-free rate puzzle, and the expectations puzzle, and show that the three puzzles are completely resolved under reasonable parameter values. Thus, we establish, conclusively, the inextricable link between the equity and bond markets, both theoretically and empirically. Our model subsumes the internal habit formation models of Sundaresan (1989) and Constantinides (1990), and, perhaps somewhat surprisingly, the external habit formation model of Campbell and Cochrane (1999).

From Equity Premium Puzzle to Expectations Puzzle: A General Equilibrium Production Economy with Stochastic Habit Formation