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Faculty of Economics

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Corrado, L., Holly, S. and Raissi, M.

Persistent Habits, optimal Monetary Policy Inertia and Interest Rate Smoothing

CWPE1247

Abstract: Dynamic stochastic general equilibrium models featuring imperfect competition and nominal rigidities have become central for the analysis of the monetary transmission mechanism and for understanding the conduct of monetary policy. However, it is agreed that the benchmark model fails to generate the persistence of output and inflation that is observed in the data. Moreover, it cannot provide a theoretically well-grounded justification for the interest rate smoothing behaviour of monetary authorities. This paper attempts to overcome these deficiencies by embedding a multiplicative habit specification in a New Keynesian model. We show that this particular form of habit formation can explain why monetary authorities smooth interest rates.

Keywords: Multiplicative habits, interest rate inertia, optimal monetary policy

JEL Codes: D12 E52 E43

Author links: Sean Holly  

PDF: http://www.econ.cam.ac.uk/research-files/repec/cam/pdf/cwpe1247.pdf

Open Access Link: https://doi.org/10.17863/CAM.1016