Abstract: 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.
Keywords: Habit formation, interest rate rules
Full paper (439 KB PDF)
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Last update: December 17, 2001
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