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Rule-of-thumb Consumers, Consumption Habits and the Taylor Principle

Listed author(s):
  • Giorgio Motta
  • Patrizio Tirelli


We show that the combination rule-of-thumb consumers and consump- tion habits dramatically aspects the dynamic performance of DSGE mod- els, resurrecting Bilbiie's (2008) inverted Taylor principle. Another origi- nal contribution of the paper is the analysis of optimal operational simple rules when RT households and habit formation in consumption are taken into account. We are able to show that the higher the share of RT con- sumers the more important for the optimal monetary policy is the stabi- lization of the wage gap, the variable that drives consumption volatility for RT consumers. The combination of consumption habits and RT con- sumers aspect the dynamic performance of the model under the optimal simple rule. Even a relatively small share of RT consumers is sufficient to generate a substantial increase in volatility. When the share of RT con- sumers is sufficiently large to require an inversion of the Taylor principle to preserve dynamic stability, optimal monetary policy is forced to gen- erate some "unconventional" impulse-response functions. For instance, a favourable productivity shock is followed by an increase in inflation and by a positive output gap.

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Paper provided by University of Milano-Bicocca, Department of Economics in its series Working Papers with number 194.

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Length: 33 pages
Date of creation: Jul 2010
Date of revision: Jul 2010
Handle: RePEc:mib:wpaper:194
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