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Temptation and forward-guidance

Marco Airaudo

Journal of Economic Theory, 2020, vol. 186, issue C

Abstract: Motivated by the extensive experimental and empirical evidence on preference reversal in consumption choices, we introduce temptation with self-control preferences into a New Keynesian model to study the effects of forward guidance in monetary policy, and the related forward guidance puzzle. In our set-up, the representative agent faces a trade off between the temptation for immediate satisfaction (liquidate wealth) with his long-run best (smooth consumption), which he manages by exerting cognitive effort (or self-control). For higher risk aversion in temptation than in commitment utility, there is discounting in the linearized Euler equation. The latter makes the response of current real activity to the announcement of a future policy change declining in the forward guidance horizon, which then helps solving the puzzle. Our framework delivers testable aggregate and policy implications that distinguish it from alternative microfoundations for discounting in the Euler equation previously used to solve the puzzle.

Keywords: Monetary policy; New Keynesian model; Forward guidance; Temptation; Self-control (search for similar items in EconPapers)
JEL-codes: E31 E32 E43 E52 E58 (search for similar items in EconPapers)
Date: 2020
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DOI: 10.1016/j.jet.2019.104989

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