Habit Formation and Interest Rate Smoothing

Luisa Corrado and Sean Holly

CDMA Conference Paper Series from Centre for Dynamic Macroeconomic Analysis

Abstract: Following a conjecture of Kozicki and Tinsley (2002) we generalise the habit formation model of consumption to allow for both a multiplicative utility function and a habit-aspiration function which is a geometrically weighted average of past consumption. The geometric form of the aspiration function addresses the recent concerns of Wendner (2002) who shows that a combination of a multiplicative utility function and an aspiration function that is an arithmetic weighted average of past consumption violates some important assumptions of utility theory. In addition, the geometric form allows us to derive an optimising model of the IS-PC form in which there is a greater degree of inertia in both inflation and output that arises from the role given to habit formation. Because the welfare function of the policymaker is that of the representative agent, and consumers dislike large changes in consumption relative to the level of consumption to which they aspire, the optimal (one-period) rule penalises changes in income and also responds sluggishly to shocks. This goes some way towards accounting for the common observation that the responses of output and inflation to shocks are drawn out, and the interest rate used for policy is persistent. We calibrate the model and find that we can replicate the persistence in interest rate setting by a monetary authority over and above that attributable to the persistence in inflation and the output gap.

Keywords: Habit formation; interest rate smoothing; AIM method. (search for similar items in EconPapers)
JEL-codes: D12 E42 E52 (search for similar items in EconPapers)
Date: 2004-09
New Economics Papers: this item is included in nep-mon
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (7)

Downloads: (external link)
https://www.st-andrews.ac.uk/CDMA/papers/cp0404.pdf (application/pdf)
Our link check indicates that this URL is bad, the error code is: 404 Not Found

Related works:
Working Paper: Habit formation and Interest-Rate Smoothing (2004)
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:san:cdmacp:0404

Access Statistics for this paper

More papers in CDMA Conference Paper Series from Centre for Dynamic Macroeconomic Analysis School of Economics and Finance, Castlecliffe, The Scores, Fife, KY16 9AZ. Contact information at EDIRC.
Bibliographic data for series maintained by The School of Economics and Finance ().