Rule-of-thumb Consumers, Consumption Habits and the Taylor Principle

Giorgio Motta and Patrizio Tirelli

No 194, Working Papers from University of Milano-Bicocca, Department of Economics

Abstract: We show that the combination rule-of-thumb consumers and consump- tion habits dramatically aspects the dynamic performance of DSGE mod- els, resurrecting Bilbiie's (2008) inverted Taylor principle. Another origi- nal contribution of the paper is the analysis of optimal operational simple rules when RT households and habit formation in consumption are taken into account. We are able to show that the higher the share of RT con- sumers the more important for the optimal monetary policy is the stabi- lization of the wage gap, the variable that drives consumption volatility for RT consumers. The combination of consumption habits and RT con- sumers aspect the dynamic performance of the model under the optimal simple rule. Even a relatively small share of RT consumers is sufficient to generate a substantial increase in volatility. When the share of RT con- sumers is sufficiently large to require an inversion of the Taylor principle to preserve dynamic stability, optimal monetary policy is forced to gen- erate some "unconventional" impulse-response functions. For instance, a favourable productivity shock is followed by an increase in inflation and by a positive output gap.

Keywords: Rule of Thumb Consumers; DSGE; Determinacy; Limited Asset; Market Participation; Taylor Principle; Optimal Simple Rule (search for similar items in EconPapers)
JEL-codes: E52 (search for similar items in EconPapers)
Pages: 33 pages
Date: 2010-07, Revised 2010-07
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (7)

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