Reference-Dependent Preferences and the Transmission of Monetary Policy

34 Pages Posted: 11 Nov 2010

See all articles by Edoardo Gaffeo

Edoardo Gaffeo

Università degli Studi di Udine - Department of Economics

Ivan Petrella

University of Warwick; Centre for Economic Policy Research (CEPR)

Damjan Pfajfar

Board of Governors of the Federal Reserve System

Emiliano Santoro

Catholic University of the Sacred Heart of Milan - Department of Economics

Date Written: October 6, 2010

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.

Keywords: Reference-dependent Preferences, Asymmetry, Monetary policy

JEL Classification: E32, E52, D03, D11

Suggested Citation

Gaffeo, Edoardo and Petrella, Ivan and Pfajfar, Damjan and Santoro, Emiliano, Reference-Dependent Preferences and the Transmission of Monetary Policy (October 6, 2010). Available at SSRN: https://ssrn.com/abstract=1703351 or http://dx.doi.org/10.2139/ssrn.1703351

Edoardo Gaffeo (Contact Author)

Università degli Studi di Udine - Department of Economics ( email )

Via Tomadini 30
33100 Udine
Italy

Ivan Petrella

University of Warwick ( email )

Gibbet Hill Rd.
Coventry, West Midlands CV4 8UW
United Kingdom

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

Damjan Pfajfar

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

Emiliano Santoro

Catholic University of the Sacred Heart of Milan - Department of Economics ( email )

20123 Milano
Italy

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