Does monetary expansion improve welfare under habit formation?
This paper studies how introducing habit formation to the two-sector small open economy model of Obstfeld and Rogoff (1995) and Lane (1997) affects the impact of a monetary surprise on welfare. In this model with endogenous habit formation, we examine agents' responses to a monetary expansion shock, taking into account the negative effect of habit formation on future consumption utility. We show that when habit formation is relatively important in the utility function, the monetary expansion decreases welfare.
Volume (Year): 33 (2013)
Issue (Month): 3 ()
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