Loss Aversion and the Asymmetric Transmission of Monetary Policy

40 Pages Posted: 16 Nov 2012

See all articles by Edoardo Gaffeo

Edoardo Gaffeo

University of Trento - Department of Economics and Management

Ivan Petrella

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

Damjan Pfajfar

Board of Governors of the Federal Reserve System

Emiliano Santoro

University of Copenhagen - Department of Economics

Multiple version iconThere are 2 versions of this paper

Date Written: July 16, 2012

Abstract

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 infl‡ation. The resulting state-dependent trade-off between output and infl‡ation stabilization recommends stronger policy activism towards in‡flation during expansions.

Keywords: Asymmetry, Monetary Policy, Business Cycle, Prospect Theory

JEL Classification: E32, E42, E52, D03, D11

Suggested Citation

Gaffeo, Edoardo and Petrella, Ivan and Pfajfar, Damjan and Santoro, Emiliano, Loss Aversion and the Asymmetric Transmission of Monetary Policy (July 16, 2012). Univ. of Copenhagen Dept. of Economics Discussion Paper No. 12-21. Available at SSRN: https://ssrn.com/abstract=2175635 or http://dx.doi.org/10.2139/ssrn.2175635

Edoardo Gaffeo

University of Trento - Department of Economics and Management ( email )

Via Inama 5
Trento, Trento 38100
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 (Contact Author)

University of Copenhagen - Department of Economics ( email )

Øster Farimagsgade 5
Bygning 26
1353 Copenhagen K.
Denmark

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