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Optimal monetary policy in a new Keynesian model with habits in consumption

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Author Info
Campbell Leith
Ioana Moldovan
Raffaele Rossi

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Abstract

While consumption habits have been utilised as a means of generating a humpshaped output response to monetary policy shocks in sticky-price New Keynesian economies, there is relatively little analysis of the impact of habits (particularly, external habits) on optimal policy. In this paper we consider the implications of external habits for optimal monetary policy, when those habits either exist at the level of the aggregate basket of consumption goods (‘superficial’ habits) or at the level of individual goods (‘deep’ habits: see Ravn, Schmitt-Grohe, and Uribe (2006)). External habits generate an additional distortion in the economy, which implies that the flex-price equilibrium will no longer be efficient and that policy faces interesting new trade-offs and potential stabilisation biases. Furthermore, the endogenous mark-up behaviour, which emerges when habits are deep, can also significantly affect the optimal policy response to shocks, as well as dramatically affecting the stabilising properties of standard simple rules.

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Paper provided by Department of Economics, University of Glasgow in its series Working Papers with number 2008_30.

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Date of creation: Nov 2008
Date of revision: Dec 2008
Handle: RePEc:gla:glaewp:2008_30

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Related research
Keywords: consumption habits; nominal inertia; optimal monetary policy;

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Find related papers by JEL classification:
E30 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - General (includes Measurement and Data)
E61 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Policy Objectives; Policy Designs and Consistency; Policy Coordination

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  1. Stephanie Schmitt-Grohé & Martín Uribe, 2007. "Optimal simple and implementable monetary and fiscal rules," Working Paper 2007-24, Federal Reserve Bank of Atlanta. [Downloadable!]
  2. Dieter Gerdesmeier & Barbara Roffia & Hans-Eggert Reimers, 2009. "Asset price misalignments and the role of money and credit," Working Paper Series 1068, European Central Bank. [Downloadable!]
  3. Morten O. Ravn & Stephanie Schmitt-Grohe, 2004. "Deep Habits," 2004 Meeting Papers 208, Society for Economic Dynamics. [Downloadable!]
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  4. Lars Ljungqvist & Harald Uhlig, 2000. "Tax Policy and Aggregate Demand Management under Catching Up with the Joneses," American Economic Review, American Economic Association, vol. 90(3), pages 356-366, June. [Downloadable!] (restricted)
  5. Luca Agnello & Ludger Schuknecht, 2009. "Booms and busts in housing markets - determinants and implications," Working Paper Series 1071, European Central Bank. [Downloadable!]
  6. Frank Smets & Rafael Wouters, 2007. "Shocks and Frictions in US Business Cycles: A Bayesian DSGE Approach," American Economic Review, American Economic Association, vol. 97(3), pages 586-606, June. [Downloadable!]
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  7. Bouakez, H. & Cardia, E. & Ruge-Murcia, F.J., 2002. "Habit Formation and the Persistence of Monetary Shocks," Cahiers de recherche 08-2002, Centre interuniversitaire de recherche en économie quantitative, CIREQ. [Downloadable!]
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  8. Kozicki, Sharon & Tinsley, P. A., 2002. "Dynamic specifications in optimizing trend-deviation macro models," Journal of Economic Dynamics and Control, Elsevier, vol. 26(9-10), pages 1585-1611, August. [Downloadable!] (restricted)
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  9. Jan Marc Berk & Beata K. Bierut, 2009. "Monetary Policy Committees - meetings and outcomes," Working Paper Series 1070, European Central Bank. [Downloadable!]
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  10. Tatiana Kirsanova & Campbell Leith & Simon Wren-Lewis, 2006. "Should Central Banks Target Consumer Prices or the Exchange Rate?," Economic Journal, Royal Economic Society, vol. 116(512), pages F208-F231, 06. [Downloadable!] (restricted)
  11. Schmitt-Grohe, Stephanie & Uribe, Martin, 2007. "Optimal simple and implementable monetary and fiscal rules," Journal of Monetary Economics, Elsevier, vol. 54(6), pages 1702-1725, September. [Downloadable!] (restricted)
  12. Frank Smets & Raf Wouters, 2003. "An Estimated Dynamic Stochastic General Equilibrium Model of the Euro Area," Journal of the European Economic Association, MIT Press, vol. 1(5), pages 1123-1175, 09. [Downloadable!] (restricted)
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  13. Campbell leith & Jim Malley, 2002. "Estimated General Equilibrium Models for the Evaluation of Monetary Policy in the US and Europe," Working Papers 2001_16, Department of Economics, University of Glasgow. [Downloadable!]
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  14. Michael Woodford, 2001. "The Taylor Rule and Optimal Monetary Policy," American Economic Review, American Economic Association, vol. 91(2), pages 232-237, May. [Downloadable!] (restricted)
  15. Levine, Paul & Pearlman, Joseph & Pierse, Richard, 2008. "Linear-quadratic approximation, external habit and targeting rules," Journal of Economic Dynamics and Control, Elsevier, vol. 32(10), pages 3315-3349, October. [Downloadable!] (restricted)
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  16. 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. [Downloadable!] (restricted)
  17. Lawrence J. Christiano & Martin Eichenbaum & Charles L. Evans, 2005. "Nominal Rigidities and the Dynamic Effects of a Shock to Monetary Policy," Journal of Political Economy, University of Chicago Press, vol. 113(1), pages 1-45, February.
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  18. Christoffel, Kai & Costain, James & de Walque, Gregory & Kuester, Keith & Linzert, Tobias & Millard, Stephen & Pierrard, Olivier, 2009. "Inflation dynamics with labour market matching: assessing alternative specifications," Bank of England working papers 375, Bank of England. [Downloadable!]
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