Habits, Wealth and Equity Risk Premium

•We incorporate a utility function that captures for flexible risk tolerance and external habits.•Wealth inequality is introduced with a mean-preserving transfer of endowment.•With external habits and concave absolute risk tolerance, wealth inequality increases the equity premium.•With convex absolute risk tolerance, increasing external habits increase the equity premium. We investigate how external habits affect the equity risk premium in an exchange economy with identical agents, except for their initial endowment. Wealth inequality is introduced with a mean-preserving transfer of endowment. We show that, when external habits are present and the absolute risk tolerance of agents is convex (concave), wealth inequality will decrease (increase) the equity risk premium. Furthermore, we find that as external habits increase, the equity risk premium increases (decreases) if agents exhibit convex (concave) absolute risk tolerance.