Consumption, intertemporal substitution effect and habit formation

This article discusses the role of the intertemporal substitution mechanism in consumption. After noting that this mechanism is central for several monetary models but, being too strong, it generally tends to reduce the ability of these models to reproduce the stylized monetary facts, it discusses the state of knowledge about the relationship between consumption and the intertemporal substitution effect. The interest of the hypothesis of habit persistence in consumption behaviour is analyzed using a simple model of intertemporal choice to show that this assumption allows weakening the intertemporal substitution mechanism, and consequently, improve the dynamic properties of the common monetary models.