Implications of Habit Formation for Optimal Monetary Policy

43 Pages Posted: 13 Dec 2005

See all articles by Thomas Laubach

Thomas Laubach

Federal Reserve Board

Jeffery D. Amato

Goldman Sachs International

Date Written: December 2001

Abstract

We study the implications for optimal monetary policy of introducing habit formation in consumption into a general equilibrium model with sticky prices. Habit formation affects the model's endogenous dynamics through its effects on both aggregate demand and households' supply of output. We show that the objective of monetary policy consistent with welfare maximization includes output stabilization, as well as inflation and output gap stabilization. We find that the variance of output increases under optimal policy, even though it acquires a higher implicit weight in the welfare function. We also find that a simple interest rate rule nearly achieves the welfare-optimal allocation, regardless of the degree of habit formation. In this rule, the optimal responses to inflation and the lagged interest rate are both declining in the size of the habit, although super-inertial policies remain optimal.

Keywords: Habit formation, interest rate rules

JEL Classification: E31, E32, E52

Suggested Citation

Laubach, Thomas and Amato, Jeffery D., Implications of Habit Formation for Optimal Monetary Policy (December 2001). FEDS Working Paper No. 2001-58; BIS Working Paper No. 121. Available at SSRN: https://ssrn.com/abstract=295622 or http://dx.doi.org/10.2139/ssrn.295622

Thomas Laubach (Contact Author)

Federal Reserve Board ( email )

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Jeffery D. Amato

Goldman Sachs International ( email )

United States

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