Reference-dependent preferences and the transmission of monetary policy

Edoardo Gaffeo, Ivan Petrella, Damjan Pfajfar and Emiliano Santoro

Working Papers of Department of Economics, Leuven from KU Leuven, Faculty of Economics and Business (FEB), Department of Economics, Leuven

Abstract: This paper proposes a novel explanation of the vast empirical evidence showing that output and prices react asymmetrically to monetary policy innovations over contractions and expansions in the business cycle. We use VAR techniques to show that monetary policy exerts stronger effects on the U.S. GDP during contractionary phases, as compared to expansionary ones. As to prices, their response is not statistically different across different cyclical stages. We show that these facts are consistent with a New Neoclassical Synthesis model based on the assumption that households. utility partly depends on deviations of their consumption from a reference level below which aversion to loss is displayed. In line with the theory developed by Kahneman and Tversky (1979), losses in consumption utility loom larger than gains. This implies state-dependent degrees of real rigidity and elasticity of intertemporal substitution in consumption that generate competing effects on the responses of output and inflation following a monetary innovation. The key predictions of the model are in line with the data. We then explore the state-dependent trade-o¤ between inflation and output stabilization that naturally arises in this context. Greater elasticity of inflation to real activity during expansionary stages of the cycle promotes a stronger degree of policy activism in the response to the expected rate of inflation under discretion, compared to what is otherwise prescribed during contractions.

Date: 2010-10
New Economics Papers: this item is included in nep-cba, nep-mac, nep-mon and nep-upt
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Citations: View citations in EconPapers (3)

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Related works:
Working Paper: Reference-dependent Preferences and the Transmission of Monetary Policy (2010)
Working Paper: Reference-Dependent Preferences and the Transmission of Monetary Policy (2010)
Working Paper: Reference-dependent Preferences and the Transmission of Monetary Policy (2010)
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Persistent link: https://EconPapers.repec.org/RePEc:ete:ceswps:ces10.28

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