Loss Aversion and the Asymmetric Transmission of Monetary Policy
40 Pages Posted: 16 Nov 2012
Date Written: July 16, 2012
There is widespread evidence that monetary policy exerts asymmetric effects on output over contractions and expansions in economic activity, while price responses display no sizeable asymmetry. To rationalize these facts we develop a dynamic general equilibrium model where households' utility depends on consumption deviations from a reference level below which loss aversion is displayed. In line with the prospect theory pioneered by Kahneman and Tversky (1979), losses in consumption loom larger than gains. State-dependent degrees of real rigidity and elasticity of intertemporal substitution in consumption generate competing effects on output and inflation. The resulting state-dependent trade-off between output and inflation stabilization recommends stronger policy activism towards inflation during expansions.
Keywords: Asymmetry, Monetary Policy, Business Cycle, Prospect Theory
JEL Classification: E32, E42, E52, D03, D11
Suggested Citation: Suggested Citation