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Time-varying volatility, precautionary saving and monetary policy

  • Hatcher, Michael

    ()

    (Cardiff University)

This paper analyses the conduct of monetary policy in an environment where households’ desire to amass precautionary savings is influenced by fluctuations in the volatilities of disturbances that hit the economy. It uses a simple New Keynesian model with external habit formation that is augmented with demand and supply disturbances whose volatilities vary over time. If volatility fluctuations are ignored by policy, interest rates are set at a suboptimal level. The extent of ‘policy bias’ is relatively small but of greater importance the higher the degree of habit formation. The reason is that habit-forming preferences raise risk aversion, increasing the importance of the precautionary savings channel through which volatility fluctuations impact upon inflation and output.

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File URL: http://www.bankofengland.co.uk/research/Documents/workingpapers/2011/wp440.pdf
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Paper provided by Bank of England in its series Bank of England working papers with number 440.

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Length: 38 pages
Date of creation: 31 Oct 2011
Date of revision:
Handle: RePEc:boe:boeewp:0440
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  1. Jesús Fernández-Villaverde & Pablo Guerrón-Quintana & Juan F. Rubio-Ramírez, 2010. "Fortune or Virtue: Time-Variant Volatilities Versus Parameter Drifting in U.S. Data," NBER Working Papers 15928, National Bureau of Economic Research, Inc.
  2. Jesus Fernandez-Villaverde & Pablo Guerron-Quintana & Juan F. Rubio-Ramirez & Martin Uribe, 2011. "Risk Matters: The Real Effects of Volatility Shocks," American Economic Review, American Economic Association, vol. 101(6), pages 2530-61, October.
  3. Andreasen, Martin, 2011. "How non-Gaussian shocks affect risk premia in non-linear DSGE models," Bank of England working papers 417, Bank of England.
  4. Andrew Benito, 2006. "Does job insecurity affect household consumption?," Oxford Economic Papers, Oxford University Press, vol. 58(1), pages 157-181, January.
  5. De Paoli, Bianca & Zabczyk, Pawel, 2009. "Why do risk premia vary over time? A theoretical investigation under habit formation," Bank of England working papers 361, Bank of England.
  6. Sydney C. Ludvigson & Alexander Michaelides, 2001. "Does Buffer-Stock Saving Explain the Smoothness and Excess Sensitivity of Consumption?," American Economic Review, American Economic Association, vol. 91(3), pages 631-647, June.
  7. Pierpaolo Benigno & Michael Woodford, 2005. "Inflation Stabilization And Welfare: The Case Of A Distorted Steady State," Journal of the European Economic Association, MIT Press, vol. 3(6), pages 1185-1236, December.
  8. Glenn D. Rudebusch & Eric T. Swanson, 2008. "Examining the bond premium puzzle with a DSGE model," Working Paper Series 2007-25, Federal Reserve Bank of San Francisco.
  9. Benigno, Gianluca & Benigno, Pierpaolo & Nisticò, Salvatore, 2013. "Second-order approximation of dynamic models with time-varying risk," Journal of Economic Dynamics and Control, Elsevier, vol. 37(7), pages 1231-1247.
  10. Bianca De Paoli & Pawel Zabczyk, 2013. "Cyclical Risk Aversion, Precautionary Saving, and Monetary Policy," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 45(1), pages 1-36, 02.
  11. Nicholas Bloom, 2007. "The Impact of Uncertainty Shocks," NBER Working Papers 13385, National Bureau of Economic Research, Inc.
  12. Juillard, Michel & Karam, Philippe & Laxton, Douglas & Pesenti, Paolo, 2006. "Welfare-based monetary policy rules in an estimated DSGE model of the US economy," Working Paper Series 0613, European Central Bank.
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