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Persistent Habits, optimal Monetary Policy Inertia and Interest Rate Smoothing

Author

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  • Corrado, L.
  • Holly, S.
  • Raissi, M.

Abstract

Dynamic stochastic general equilibrium models featuring imperfect competition and nominal rigidities have become central for the analysis of the monetary transmission mechanism and for understanding the conduct of monetary policy. However, it is agreed that the benchmark model fails to generate the persistence of output and inflation that is observed in the data. Moreover, it cannot provide a theoretically well-grounded justification for the interest rate smoothing behaviour of monetary authorities. This paper attempts to overcome these deficiencies by embedding a multiplicative habit specification in a New Keynesian model. We show that this particular form of habit formation can explain why monetary authorities smooth interest rates.

Suggested Citation

  • Corrado, L. & Holly, S. & Raissi, M., 2012. "Persistent Habits, optimal Monetary Policy Inertia and Interest Rate Smoothing," Cambridge Working Papers in Economics 1247, Faculty of Economics, University of Cambridge.
  • Handle: RePEc:cam:camdae:1247
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    References listed on IDEAS

    as
    1. Becker, Gary S, 1992. "Habits, Addictions, and Traditions," Kyklos, Wiley Blackwell, vol. 45(3), pages 327-345.
    2. Christopher D. Carroll, 2001. "A Theory of the Consumption Function, with and without Liquidity Constraints," Journal of Economic Perspectives, American Economic Association, vol. 15(3), pages 23-45, Summer.
    3. Abel Andrew B. & Mailath George J., 1994. "Financing Losers in Competitive Markets," Journal of Financial Intermediation, Elsevier, pages 139-165.
    4. Amato, Jeffery D. & Laubach, Thomas, 2004. "Implications of habit formation for optimal monetary policy," Journal of Monetary Economics, Elsevier, pages 305-325.
    5. Mark Gertler & Jordi Gali & Richard Clarida, 1999. "The Science of Monetary Policy: A New Keynesian Perspective," Journal of Economic Literature, American Economic Association, pages 1661-1707.
    6. John Y. Campbell & John H. Cochrane, 1994. "By force of habit: a consumption-based explanation of aggregate stock market behavior," Working Papers 94-17, Federal Reserve Bank of Philadelphia.
    7. Corrado, Luisa & Holly, Sean, 2011. "Multiplicative habit formation and consumption: A note," Economics Letters, Elsevier, vol. 113(2), pages 116-119.
    8. Abel, Andrew B, 1990. "Asset Prices under Habit Formation and Catching Up with the Joneses," American Economic Review, American Economic Association, pages 38-42.
    9. Carroll, Christopher D., 2000. "Solving consumption models with multiplicative habits," Economics Letters, Elsevier, vol. 68(1), pages 67-77, July.
    10. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, vol. 12(3), pages 383-398, September.
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    More about this item

    Keywords

    Multiplicative habits; interest rate inertia; optimal monetary policy.;

    JEL classification:

    • D12 - Microeconomics - - Household Behavior - - - Consumer Economics: Empirical Analysis
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects

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