Optimal Monetary Policy in a Small Open Economy with Habit Formation and Nominal Rigidities
IMF Working Papers, January 1, 2003
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- Optimal Monetary Policy in a Small Open Economy with Habit Formation and Nominal Rigidities
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Bibliographic details
- Authors: Yongseung Jung, Woon Gyu Choi
- Published: January 1, 2003
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9781451842203.001
Summary of findings
- Introducing habit formation into an open economy macroeconomic model with price stickiness, the study examines the characteristics of an optimal monetary policy.
- The optimal policy rule:
- Entails interest rate smoothing.
- Responds to the lagged values of the foreign interest rate and domestic technology shocks as well as their current values.
- Habit formation effects:
- Enrich the dynamics of the economy with a persistent, hump-shaped response of consumption to shocks.
- Welfare and macroeconomic variability:
- When habit formation does matter, the optimal policy rule achieves a greater welfare improvement over alternative policy rules by achieving lower macroeconomic variability.
Model features and mechanisms
- Key structural elements:
- Habit formation in consumer preferences.
- Price stickiness (nominal rigidities) in an open economy framework.
- Dynamic implications:
- Persistence in consumption responses to shocks.
- Hump-shaped consumption paths following shocks due to habit formation.
Policy implications and recommendations
- Optimal monetary policy should incorporate:
- Interest rate smoothing as a design feature.
- Responses to both current and lagged foreign interest rates.
- Responses to both current and lagged domestic technology shocks.
- Rationale:
- Accounting for habit formation in policy design can yield welfare gains by reducing macroeconomic variability relative to alternative policy rules.