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Optimal Monetary Policy in a Small Open Economy with Habit Formation and Nominal Rigidities

  • Yongseung Jung
  • Woon Gyu Choi

Introducing habit formation into an open economy macroeconomic model with price stickiness, we examine the characteristics of an optimal monetary policy. We find that, first, the optimal policy rule entails interest rate smoothing and responds to the lagged values of the foreign interest rate and domestic technology shocks as well as their current values. Second, habit formation enriches the dynamics of the economy with a persistent, hump-shaped response of consumption to shocks. Finally, when habit formation does matter, the optimal policy rule achieves a greater welfare improvement over alternative policy rules by achieving lower macroeconomic variability.

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Paper provided by International Monetary Fund in its series IMF Working Papers with number 03/5.

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Length: 33
Date of creation: 01 Jan 2003
Date of revision:
Handle: RePEc:imf:imfwpa:03/5
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  1. Michael Devereux & Charles Engel & Cedric Tille, 1999. "Exchange-Rate Pass-Through and the Welfare Effects of the Euro," Discussion Papers in Economics at the University of Washington 0034, Department of Economics at the University of Washington.
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  5. Jordi Galí & Tommaso Monacelli, 2003. "Monetary Policy and Exchange Rate Volatility in a Small Open Economy," Working Papers 11, Barcelona Graduate School of Economics.
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  9. Lane, Philip R. & Milesi-Ferretti, Gian Maria, 2001. "Long-Term Capital Movements," CEPR Discussion Papers 2873, C.E.P.R. Discussion Papers.
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  10. 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.
  11. Rudebusch, Glenn D., 1995. "Federal Reserve interest rate targeting, rational expectations, and the term structure," Journal of Monetary Economics, Elsevier, vol. 35(2), pages 245-274, April.
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  13. Martin Eichenbaum & Charles Evans, 1992. "Some empirical evidence on the effects of monetary policy shocks on exchange rates," Working Paper Series, Macroeconomic Issues 92-32, Federal Reserve Bank of Chicago.
  14. Ben S. Bernanke & Michael Woodford, 1997. "Inflation forecasts and monetary policy," Proceedings, Federal Reserve Bank of Cleveland, pages 653-686.
  15. Robert G. King & Alexander L. Wolman, 1996. "Inflation targeting in a St. Louis model of the 21st century," Review, Federal Reserve Bank of St. Louis, issue May, pages 83-107.
  16. Michael Woodford, 1996. "Control of the Public Debt: A Requirement for Price Stability?," NBER Working Papers 5684, National Bureau of Economic Research, Inc.
  17. Yun, Tack, 1996. "Nominal price rigidity, money supply endogeneity, and business cycles," Journal of Monetary Economics, Elsevier, vol. 37(2-3), pages 345-370, April.
  18. Choi, Woon Gyu, 1999. "Estimating the Discount Rate Policy Reaction Function of the Monetary Authority," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 14(4), pages 379-401, July-Aug..
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