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Loss Aversion and the Asymmetric Transmission of Monetary Policy

  • Edoardo Gaffeo

    (University of Trento)

  • Ivan Petrella

    (Birkbeck, University of London)

  • Damjan Pfajfar

    (University of Tilburg)

  • Emiliano Santoro

    (Catholic University of Milan and University of Copenhagen)

There is widespread evidence that monetary policy exerts asymmetric effects on output over contractions and expansions in economic activity, while price responses display no sizeable asymmetry. To rationalize these facts we develop a dynamic general equilibrium model where households' utility depends on consumption deviations from a reference level below which loss aversion is displayed. In line with the prospect theory pioneered by Kahneman and Tversky (1979), losses in consumption loom larger than gains. State-dependent degrees of real rigidity and elasticity of intertemporal substitution in consumption generate competing effects on output and infl?ation. The resulting state-dependent trade-off between output and infl?ation stabilization recommends stronger policy activism towards in?flation during expansions

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Paper provided by University of Copenhagen. Department of Economics in its series Discussion Papers with number 12-21.

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Length: 39 pages
Date of creation: 16 Jul 2012
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Handle: RePEc:kud:kuiedp:1221
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