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Implications of habit formation for optimal monetary policy

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  • Amato, Jeffery D.
  • Laubach, Thomas

Abstract

We study the implications for optimal monetary policy of introducing habit formation in consumption into a general equilibrium model with sticky prices. Habit formation affects the model's endogenous dynamics through its effects on both aggregate demand and households' supply of output. We show that the objective of monetary policy consistent with welfare maximisation includes output stablisation, as well as inflation and output gap stablisation. We find that the variance of output increases under optimal policy, even though it acquires a higher implicit weight in the welfare function. We also find that a simple interest rate rule nearly achieves the welfare-optimal allocation, regardless of the degree of habit formation. In this rule, the optimal responses to inflation and the lagged interest rate are both declining in the size of the habit, although super-inertial policies remain optimal.

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Bibliographic Info

Article provided by Elsevier in its journal Journal of Monetary Economics.

Volume (Year): 51 (2004)
Issue (Month): 2 (March)
Pages: 305-325

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Handle: RePEc:eee:moneco:v:51:y:2004:i:2:p:305-325

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Web page: http://www.elsevier.com/locate/inca/505566

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  7. Amato, Jeffery D. & Laubach, Thomas, 2004. "Implications of habit formation for optimal monetary policy," Journal of Monetary Economics, Elsevier, vol. 51(2), pages 305-325, March.
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  18. Rochelle M. Edge, 2000. "Time-to-build, time-to-plan, habit-persistence, and the liquidity effect," International Finance Discussion Papers 673, Board of Governors of the Federal Reserve System (U.S.).
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