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Discretion versus Inflation Targeting in Economies with Relative Habit Persistence

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  • Yongseung Jung

    (Kyung Hee University)

Abstract

This paper sets up a canonical new Keynesian model with habit persistence in consumption. The paper estimates key parameters using maximum likelihood and shows that the habit persistence improves the explanatory power of the model over the business cycle, irrespective of habit formation way. If the distortions associated with external habit are not completely eliminated by the fiscal policy, then the remaining external habit entails a gap between the private marginal rate of substitution between consumption and labor and the social marginal rate of substitution, generating an endogenous trade-off between the stabilization of welfare-relevant output gap and inflation. Under this circumstance, discretion, partially taking into account the trade-off between output gap and inflation, can be better than a strict inflation targeting rule in welfare dimension if the fiscal authority does not implement any tax policy to eliminate the distortions associated with external habit. The monetary policy to deal with distortions associated with external habit is less effective in the ratio external habit model than in the difference habit model, resulting in a higher the inflation rate in the ratio external habit model than the inflation rate in the difference habit model.

Suggested Citation

  • Yongseung Jung, 2016. "Discretion versus Inflation Targeting in Economies with Relative Habit Persistence," Korean Economic Review, Korean Economic Association, vol. 32, pages 167-200.
  • Handle: RePEc:kea:keappr:ker-20160630-32-1-07
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    References listed on IDEAS

    as
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    More about this item

    Keywords

    Discretion; Ratio External Habit; Sticky Prices; Welfare;
    All these keywords.

    JEL classification:

    • E21 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy

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