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Implications of habit formation for optimal monetary policy

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  • Jeffery D. Amato

    (Goldman Sachs International)

  • Thomas Laubach

    (Federal Reserve Board)

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

Paper provided by Bank for International Settlements in its series BIS Working Papers with number 121.

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Length: 45 pages
Date of creation: Nov 2002
Date of revision:
Handle: RePEc:bis:biswps:121

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Keywords: interest rate rules; habit formation; optimal monetary policy;

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References

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  1. Svensson, Lars E.O. & Rudebusch , Glenn, 1998. "Policy Rules for Inflation Targeting," Seminar Papers, Stockholm University, Institute for International Economic Studies 637, Stockholm University, Institute for International Economic Studies.
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  5. Julio J. Rotemberg & Michael Woodford, 1999. "Interest Rate Rules in an Estimated Sticky Price Model," NBER Chapters, in: Monetary Policy Rules, pages 57-126 National Bureau of Economic Research, Inc.
  6. Abel, A.B., 1990. "Asset Prices Under Habit Formation And Catching Up With The Joneses," Weiss Center Working Papers, Wharton School - Weiss Center for International Financial Research 1-90, Wharton School - Weiss Center for International Financial Research.
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  9. Amato, Jeffery D. & Laubach, Thomas, 2004. "Implications of habit formation for optimal monetary policy," Journal of Monetary Economics, Elsevier, Elsevier, vol. 51(2), pages 305-325, March.
  10. Alan S. Blinder, 1994. "On Sticky Prices: Academic Theories Meet the Real World," NBER Chapters, in: Monetary Policy, pages 117-154 National Bureau of Economic Research, Inc.
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  12. Christopher J. Erceg & Dale W. Henderson & Andrew T. Levin, 1999. "Optimal monetary policy with staggered wage and price contracts," International Finance Discussion Papers, Board of Governors of the Federal Reserve System (U.S.) 640, Board of Governors of the Federal Reserve System (U.S.).
  13. Coenen, Guenter & Wieland, Volker, 2003. "A Small Estimated Euro Area Model with Rational Expectations and Nominal Rigidities," CFS Working Paper Series 2003/08, Center for Financial Studies (CFS).
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  17. Taylor, John B., 1993. "Discretion versus policy rules in practice," Carnegie-Rochester Conference Series on Public Policy, Elsevier, Elsevier, vol. 39(1), pages 195-214, December.
  18. Rochelle M. Edge, 2000. "Time-to-build, time-to-plan, habit-persistence, and the liquidity effect," International Finance Discussion Papers, Board of Governors of the Federal Reserve System (U.S.) 673, Board of Governors of the Federal Reserve System (U.S.).
  19. Julio Rotemberg & Michael Woodford, 1997. "An Optimization-Based Econometric Framework for the Evaluation of Monetary Policy," NBER Chapters, in: NBER Macroeconomics Annual 1997, Volume 12, pages 297-361 National Bureau of Economic Research, Inc.
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  22. Jody Overland & Christopher D. Carroll & David N. Weil, 2000. "Saving and Growth with Habit Formation," American Economic Review, American Economic Association, American Economic Association, vol. 90(3), pages 341-355, June.
  23. Jeffrey C. Fuhrer, 2000. "Habit Formation in Consumption and Its Implications for Monetary-Policy Models," American Economic Review, American Economic Association, American Economic Association, vol. 90(3), pages 367-390, June.
  24. Attanasio, Orazio P & Weber, Guglielmo, 1993. "Consumption Growth, the Interest Rate and Aggregation," Review of Economic Studies, Wiley Blackwell, Wiley Blackwell, vol. 60(3), pages 631-49, July.
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