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Reference-dependent preferences and the transmission of monetary policy

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  • Edoardo GAFFEO
  • Ivan PETRELLA
  • Damjan PFAJFAR
  • Emiliano SANTORO

Abstract

This paper proposes a novel explanation of the vast empirical evidence showing that output and prices react asymmetrically to monetary policy innovations over contractions and expansions in the business cycle. We use VAR techniques to show that monetary policy exerts stronger effects on the U.S. GDP during contractionary phases, as compared to expansionary ones. As to prices, their response is not statistically different across different cyclical stages. We show that these facts are consistent with a New Neoclassical Synthesis model based on the assumption that households. utility partly depends on deviations of their consumption from a reference level below which aversion to loss is displayed. In line with the theory developed by Kahneman and Tversky (1979), losses in consumption utility loom larger than gains. This implies state-dependent degrees of real rigidity and elasticity of intertemporal substitution in consumption that generate competing effects on the responses of output and inflation following a monetary innovation. The key predictions of the model are in line with the data. We then explore the state-dependent trade-o¤ between inflation and output stabilization that naturally arises in this context. Greater elasticity of inflation to real activity during expansionary stages of the cycle promotes a stronger degree of policy activism in the response to the expected rate of inflation under discretion, compared to what is otherwise prescribed during contractions.

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Paper provided by Katholieke Universiteit Leuven, Centrum voor Economische Studiën in its series Center for Economic Studies - Discussion papers with number ces10.28.

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Date of creation: Oct 2010
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Handle: RePEc:ete:ceswps:ces10.28

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  1. Troy Davig & Eric M. Leeper, 2006. "Endogenous Monetary Policy Regime Change," Caepr Working Papers 2006-002, Center for Applied Economics and Policy Research, Economics Department, Indiana University Bloomington.
  2. Rina Rosenblatt-Wisch, 2007. "Loss Aversion in Aggregate Macroeconomic Time Series," Working Papers 2007-06, Swiss National Bank.
  3. Kobberling, Veronika & Wakker, Peter P., 2005. "An index of loss aversion," Journal of Economic Theory, Elsevier, vol. 122(1), pages 119-131, May.
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Cited by:
  1. Giuseppe Ciccarone & Enrico Marchetti, 2011. "Macroeconomic effects of loss aversion in a signal extraction model," Working Papers 148, University of Rome La Sapienza, Department of Public Economics.
  2. Mumtaz, Haroon & Surico, Paolo, 2011. "Estimating the Aggregate Consumption Euler Equation with State-Dependent Parameters," CEPR Discussion Papers 8233, C.E.P.R. Discussion Papers.
  3. Ciccarone, Giuseppe & Marchetti, Enrico, 2013. "Rational expectations and loss aversion: Potential output and welfare implications," Journal of Economic Behavior & Organization, Elsevier, vol. 86(C), pages 24-36.

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