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Implications of habit formation for optimal monetary policy

  • Jeffery D. Amato
  • Thomas Laubach

We study the implications for optimal monetary policy of introducing habit formation in consumption into a general equilibrium model with sticky prices. Habit formation affects the model's endogenous dynamics through its effects on both aggregate demand and households' supply of output. We show that the objective of monetary policy consistent with welfare maximization includes output stabilization, as well as inflation and output gap stabilization. We find that the variance of output increases under optimal policy, even though it acquires a higher implicit weight in the welfare function. We also find that a simple interest rate rule nearly achieves the welfare-optimal allocation, regardless of the degree of habit formation. In this rule, the optimal responses to inflation and the lagged interest rate are both declining in the size of the habit, although super-inertial policies remain optimal.

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Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series Finance and Economics Discussion Series with number 2001-58.

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Date of creation: 2001
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Handle: RePEc:fip:fedgfe:2001-58
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  1. Jeff Fuhrer & George Moore, 1993. "Inflation persistence," Proceedings, Board of Governors of the Federal Reserve System (U.S.).
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  8. Christopher D. Carroll & Jody Overland & David N. Weil, 1995. "Saving and growth with habit formation," Finance and Economics Discussion Series 95-42, Board of Governors of the Federal Reserve System (U.S.).
  9. Jeffery D. Amato & Thomas Laubach, 2002. "Implications of habit formation for optimal monetary policy," BIS Working Papers 121, Bank for International Settlements.
  10. Erceg, Christopher J. & Henderson, Dale W. & Levin, Andrew T., 2000. "Optimal monetary policy with staggered wage and price contracts," Journal of Monetary Economics, Elsevier, vol. 46(2), pages 281-313, October.
  11. Athanasios Orphanides, 1998. "Monetary policy evaluation with noisy information," Finance and Economics Discussion Series 1998-50, Board of Governors of the Federal Reserve System (U.S.).
  12. Attanasio, Orazio P & Weber, Guglielmo, 1993. "Consumption Growth, the Interest Rate and Aggregation," Review of Economic Studies, Wiley Blackwell, vol. 60(3), pages 631-49, July.
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  14. Woodford, M., 1999. "Optimal Monetary Policy Inertia.," Papers 666, Stockholm - International Economic Studies.
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  16. Jeffrey C. Fuhrer, 2000. "Habit Formation in Consumption and Its Implications for Monetary-Policy Models," American Economic Review, American Economic Association, vol. 90(3), pages 367-390, June.
  17. Gunter Coenen & Volker Wieland, 2000. "A Small Estimated Euro-Area Model with Rational Expectations and Nominal Rigidities," Econometric Society World Congress 2000 Contributed Papers 1284, Econometric Society.
  18. John B. Taylor, 1999. "Monetary Policy Rules," NBER Books, National Bureau of Economic Research, Inc, number tayl99-1, October.
  19. Michael Woodford, 2001. "Inflation Stabilization and Welfare," NBER Working Papers 8071, National Bureau of Economic Research, Inc.
  20. Robert E. Hall, 1981. "Intertemporal Substitution in Consumption," NBER Working Papers 0720, National Bureau of Economic Research, Inc.
  21. Rochelle M. Edge, 2000. "Time-to-build, time-to-plan, habit-persistence, and the liquidity effect," International Finance Discussion Papers 673, Board of Governors of the Federal Reserve System (U.S.).
  22. N. Gregory Mankiw, 1994. "Monetary Policy," NBER Books, National Bureau of Economic Research, Inc, number greg94-1, October.
  23. Karen E. Dynan, 2000. "Habit Formation in Consumer Preferences: Evidence from Panel Data," American Economic Review, American Economic Association, vol. 90(3), pages 391-406, June.
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  25. Alan S. Blinder, 1994. "On Sticky Prices: Academic Theories Meet the Real World," NBER Chapters, in: Monetary Policy, pages 117-154 National Bureau of Economic Research, Inc.
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