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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. Abel, A.B., 1990. "Asset Prices Under Habit Formation And Catching Up With The Joneses," Weiss Center Working Papers 1-90, Wharton School - Weiss Center for International Financial Research.
  2. Michael Woodford, 1999. "Optimal monetary policy inertia," Proceedings, Federal Reserve Bank of San Francisco.
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  5. Taylor, John B., 1993. "Discretion versus policy rules in practice," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 39(1), pages 195-214, December.
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  7. Julio J. Rotemberg & Michael Woodford, 1999. "Interest Rate Rules in an Estimated Sticky Price Model," NBER Chapters, in: Monetary Policy Rules, pages 57-126 National Bureau of Economic Research, Inc.
  8. Coenen, Guenter & Wieland, Volker, 2003. "A Small Estimated Euro Area Model with Rational Expectations and Nominal Rigidities," CFS Working Paper Series 2003/08, Center for Financial Studies (CFS).
  9. 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.
  10. Jeff Fuhrer & George Moore, 1995. "Inflation Persistence," The Quarterly Journal of Economics, Oxford University Press, vol. 110(1), pages 127-159.
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  15. Jeffery D. Amato & Thomas Laubach, 2002. "Implications of habit formation for optimal monetary policy," BIS Working Papers 121, Bank for International Settlements.
  16. John B. Taylor, 1999. "Monetary Policy Rules," NBER Books, National Bureau of Economic Research, Inc, number tayl99-1, September.
  17. 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.
  18. Michael Woodford, 2001. "Inflation Stabilization and Welfare," NBER Working Papers 8071, National Bureau of Economic Research, Inc.
  19. 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.
  20. Taylor, John B, 1979. "Estimation and Control of a Macroeconomic Model with Rational Expectations," Econometrica, Econometric Society, vol. 47(5), pages 1267-86, September.
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  23. N. Gregory Mankiw, 1994. "Monetary Policy," NBER Books, National Bureau of Economic Research, Inc, number greg94-1, September.
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  25. Orazio P. Attanasio & Guglielmo Weber, 1993. "Consumption Growth, the Interest Rate and Aggregation," Review of Economic Studies, Oxford University Press, vol. 60(3), pages 631-649.
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