Monetary policy with non-homothetic preferences

This paper studies the role of non-homothetic preferences for monetary policy from both a positive and a normative perspective. It draws on a dynamic stochastic general equilibrium model characterized by preferences with a variable elasticity of substitution among goods and with price adjustment costs à la Rotemberg. These preferences have remarkable implications for monetary policy. Three main results stand out from a comparison of models with an increasing and a constant elasticity. First, an increasing elasticity induces novel intertemporal substitution effects that amplify the propagation of monetary and technology shocks. Second, it weakens the ability of a simple Taylor rule to attain a given level of macroeconomic stabilization. Third, the smallest welfare losses can be attained by stabilizing both inflation and output, in contrast to the prevailing view - based on models with a constant elasticity - that the best thing the monetary authority can do is to control inflation only.