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Habit formation and Interest-Rate Smoothing

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Author Info
Sean Holly
Luisa Corrado

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Abstract

Following a conjecture of Kozicki and Tinsley we generalises the habit formation model of consumption to allow for both a multiplicative utility function and a habit\aspiration function which is a geometrically weighted average of past consumption. The geometric form of the aspiration function addresses the recent concerns of Wendner (2002) who shows that a combination of a multiplicative utility function and an aspiration function that is an arithmetic weighted average of past consumption violates some important assumptions of utility theory. The geometric form allows us to derive an optimising model of the IS-PC form in which there is a greater degree of inertia in both inflation and output that arises from the role given to habit formation. The geometric form also allows us to derive a rule for the interest rate in which there is equivalent inertia in the interest rate. Because the welfare function of the policymaker is that of the representative agent, the optimal rule penalises changes in income and also responds sluggishly to shocks. This goes some way to accounting for the common observation that the responses of output and inflation to shocks are drawn out, and the interest rate used for policy is persistent. We calibrate the model and find that we can replicate the persistence in interest rate setting by a monetary authority over and above that attributable to the persistence in inflation and the output gap.

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Paper provided by Society for Computational Economics in its series Computing in Economics and Finance 2004 with number 215.

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Date of creation: 11 Aug 2004
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Handle: RePEc:sce:scecf4:215

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Related research
Keywords: habit formation; multiplicative utility; interest rate smoothing; monetary policy;

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Find related papers by JEL classification:
E12 - Macroeconomics and Monetary Economics - - General Aggregative Models - - - Keynes; Keynesian; Post-Keynesian

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  1. Sharon Kozicki & Peter Tinsley, 2005. "Term structure transmission of monetary policy," Research Working Paper RWP 05-06, Federal Reserve Bank of Kansas City. [Downloadable!]
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  2. Arnab Bhattacharjee & Sean Holly, 2006. " Taking Personalities out of Monetary Policy Decision Making? Interactions, Heterogeneity and Committee Decisions in the Bank of England’s MPC," CDMA Working Paper Series 0612, Centre for Dynamic Macroeconomic Analysis. [Downloadable!]
  3. Jagjit Chadha & Sean Holly, 2006. "Macroeconomic Models and the Yield Curve," Computing in Economics and Finance 2006 105, Society for Computational Economics. [Downloadable!]
  4. Michael Funke & Sebastian Weber & Jörg Döpke & Sean Holly, 2008. "The Cross-Section of Output and Inflation in a Dynamic Stochastic General Equilibrium Model with Sticky Prices," Quantitative Macroeconomics Working Papers 20809, Hamburg University, Department of Economics. [Downloadable!]
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  5. Bhattacharjee, A. & Holly, S., 2005. "Inflation Targeting, Committee Decision Making and Uncertainty: The case of the Bank of England’s MPC," Cambridge Working Papers in Economics 0530, Faculty of Economics, University of Cambridge. [Downloadable!]
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  6. Chadha, J.S. & Holly, S., 2006. "Macroeconomic Models and the Yield Curve: An assessment of the Fit," Cambridge Working Papers in Economics 0640, Faculty of Economics, University of Cambridge. [Downloadable!]
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