Optimal monetary policy in a two-country new Keynesian model with deep consumption habits

Okano, Mitsuhiro (2021): Optimal monetary policy in a two-country new Keynesian model with deep consumption habits.

Abstract

This study develops a two-country New Keynesian (NK) model incorporating deep habits in consumption to analyze macroeconomic dynamics under the optimal coordinated monetary policy. The central bank adjusts interest rates more aggressively in response to structural shocks in an open economy than in a closed economy. Deep habits strengthen the central bank's incentive to adjust terms of trade through interest rates due to habit formation and counter-cyclical markup behavior, creating price inelasticity in demand. Deep habits also lead to deviations from the law of one price, reflected in goods-specific real exchange rates, which the degree of home bias influences. Finally, this study compares international policy coordination to noncoordination to analyze welfare gains, showing that they depend on key structural factors like price rigidity, deep habits, and home bias. Policy coordination stabilizes domestic output and inflation by internalizing externalities in terms of trade and consumption.

• Item Type: MPRA Paper
• Language: English
• Keywords: Optimal monetary policy; Deep habit; Policy coordination; Commitment
• Subjects: E - Macroeconomics and Monetary Economics > E5 - Monetary Policy, Central Banking, and the Supply of Money and Credit > E52 - Monetary Policy; E - Macroeconomics and Monetary Economics > E5 - Monetary Policy, Central Banking, and the Supply of Money and Credit > E58 - Central Banks and Their Policies; F - International Economics > F4 - Macroeconomic Aspects of International Trade and Finance > F41 - Open Economy Macroeconomics

References

Abel, Andrew (1990) “Asset Prices under Habit Formation and Catching Up with the Joneses,” American Economic Review, 80 (2), 38–42.

Amato, Jeffery D. and Thomas Laubach (1999) “The value of interest rate smoothing : how the private sector helps the Federal Reserve,” Economic Review, 84 (Q III), 47–64.

Amato, Jeffery D and Thomas Laubach (2004) “Implications of habit formation for optimal monetary policy,” Journal of Monetary Economics, 51 (2), 305–325, https://doi.org/10. 1016/j.jmoneco.2003.05.002.

Backus, David K., Patrick J. Kehoe, and Finn E. Kydtand (1995) 11 International Business Cycles: Theory and Evidence, 331–356, Princeton: Princeton University Press, doi:10.1515/ 9780691218052-015.

Benigno, Gianluca and Pierpaolo Benigno (2006) “Designing targeting rules for international monetary policy cooperation,” Journal of Monetary Economics, 53 (3), 473–506.

Bils, Mark (1989) “Pricing in a Customer Market,” The Quarterly Journal of Economics, 104 (4), 699–718.

Bodenstein, Martin, Luca Guerrieri, and Joe LaBriola (2019) “Macroeconomic policy games,” Journal of Monetary Economics, 101, 64–81, https://doi.org/10.1016/j.jmoneco.2018.07.015.

Calvo, Guillermo A (1983) “Staggered prices in a utility-maximizing framework,” Journal of Monetary Economics, 12 (3), 383–398.

Cantore, Cristiano, Paul Levine, and Giovanni Melina (2014) “Deep versus superficial habit: It’s all in the persistence,” School of Economics Discussion Papers 0714, School of Economics, University of Surrey.

Chari, V V, Patrick J Kehoe, and Ellen R McGrattan (2002) “Can Sticky Price Models Generate Volatile and Persistent Real Exchange Rates?” The Review of Economic Studies, 69 (3), 533–563, 10.1111/1467-937x.00216.

Christiano, Lawrence J, Martin Eichenbaum, and Charles L Evans (2005) “Nominal Rigidities and the Dynamic Effects of a Shock to Monetary Policy,” Journal of Political Economy (1), 10.1086/426038.

Clarida, Richard, Jordi Gal´ ı, and Mark Gertler (1999) “The Science of Monetary Policy: A New Keynesian Perspective,” Journal of Economic Literatureb, 37 (4), 1661–1707, 10.1257/ jel.37.4.1661.

Clarida, Richard, Jordi Gal´ ı, and Mark Gertler (2002) “A simple framework for inter- national monetary policy analysis,” Journal of Monetary Economics, 49 (5), 879–904, 10.1016/s0304-3932(02)00128-9.

Corsetti, Giancarlo and Luca Dedola (2005) “A macroeconomic model of international price discrimination,” Journal of International Economics, 67 (1), 129–155.

Corsetti, Giancarlo, Luca Dedola, and Sylvain Leduc (2010) “Chapter 16 - Optimal Monetary Policy in Open Economies,” in Friedman, Benjamin M. and Michael Woodford eds. Handbook of Monetary Economics, 3, 861–933: Elsevier, https://doi.org/10.1016/B978-0-444-53454-5.00004-9.

De Paoli, Bianca (2009) “Monetary policy and welfare in a small open economy,” Journal of International Economics, 77 (1), 11–22, https://doi.org/10.1016/j.jinteco.2008.09.007.

Devereux, Michael B. and Charles Engel (2003) “Monetary Policy in the Open Economy Revisited: Price Setting and Exchange-Rate Flexibility,” The Review of Economic Studies, 70 (4), 765–783, 10.1111/1467-937X.00266.

Engel, Charles (2011) “Currency Misalignments and Optimal Monetary Policy: A Reexamination,” American Economic Review, 101, 2796–2822.

Fuhrer, Jeffrey C. (2000) “Habit Formation in Consumption and Its Implications for Monetary-Policy Models,” American Economic Review, 90 (3), 367–390, 10.1257/aer.90.3.367.

Fujiwara, Ippei and Jiao Wang (2017) “Optimal monetary policy in open economies revisited,” Journal of International Economics, 108 (C), 300–314.

Gal´ ı, Jordi and Tommaso Monacelli (2005) “Monetary Policy and Exchange Rate Volatility in a Small Open Economy,” The Review of Economic Studies, 72 (3), 707–734, 10.1111/j. 1467-937X.2005.00349.x.

Givens, Gregory E. (2016) “On the gains from monetary policy commitment under deep habits,” Journal of Macroeconomics, 50, 19–36, https://doi.org/10.1016/j.jmacro.2016.08.006.

Hong, Sungki (2019) “Customer Capital, Markup Cyclicality, and Amplification,” 2019 Meeting Papers 959, Society for Economic Dynamics.

Ida, Daisuke and Mitsuhiro Okano (2021) “Delegating Optimal Monetary Policy Inertia in a Small-Open Economy,” The B.E. Journal of Macroeconomics, 21 (2), 473–507, doi:10.1515/ bejm-2020-0181.

Ida, Daisuke and Mitsuhiro Okano (2023a) “International heterogeneity of nominal wages and optimal monetary policy,” International Finance, 26 (2), 112–138, https://doi.org/10.1111/infi.12429.

Ida, Daisuke and Mitsuhiro Okano (2023b) “Optimal monetary policy delegation in a small-open new Keynesian model with robust control,” Economic Modelling, 120, 106154, https://doi.org/10.1016/j.econmod. 2022.106154.

Ireland, Peter N (2004) “Technology shocks in the new Keynesian model,” Review of Economics and Statistics, 86 (4), 923–936.

Jacob, Punnoose and Lenno Uusk¨ ula (2019) “Deep habits and exchange rate pass-through,” Journal of Economic Dynamics and Control, 105 (C), 67–89, 10.1016/j.jedc.2019.05.01.

Jacob, Punnose (2015) “Deep Habits, Price Rigidities, and the Consumption Response to Government Spending,” Journal of Money, Credit and Banking, 47 (2/3), 481–509.

Kim, Myunghyun (2023) “Gains from monetary policy cooperation under asymmetric currency pricing,” European Economic Review, 151, 104357, https://doi.org/10.1016/j.euroecorev. 2022.104357.

Kormilitsina, Anna and Sarah Zubairy (2018) “Propagation Mechanisms for Government Spending Shocks: A Bayesian Comparison,” Journal of Money, Credit and Banking, 50 (7), 1571–1616, 10.1111/jmcb.12555.

Landi, Valerio Nispi (2021) “Optimizing Simple Policy Rules,” https://sites.google.com/ site/valerionispi/dsges, Accessed on May 5, 2023.

Leith, Campbell, Ioana Moldovan, and Raffaele Rossi (2009) “Monetary and Fiscal Policy under Deep Habits,” SIRE Discussion Papers 2009-47, Scottish Institute for Research in Economics (SIRE).

Leith, Campbell, Ioana Moldovan, and Raffaele Rossi (2012) “Optimal monetary policy in a New Keynesian model with habits in consumption,” Review of Economic Dynamics, 15 (3), 416–435, https://doi.org/10.1016/j.red.2012.03.001.

Leith, Campbell, Ioana Moldovan, and Raffaele Rossi (2015) “Monetary and fiscal policy under deep habits,” Journal of Economic Dynamics and Control, 52 (C), 55–74, 10.1016/j.jedc.2014.11.00.

Levine, Paul, Joseph Pearlman, and Richard Pierse (2008) “Linear-quadratic approximation, external habit and targeting rules,” Journal of Economic Dynamics and Control, 32, 3315–3349.

Lombardo, Giovanni and David Vestin (2008) “Welfare implications of Calvo vs. Rotemberg-pricing assumptions,” Economics Letters, 100 (2), 275–279.

Lubik, Thomas A. and Wing Leong Teo (2014) “Deep Habits in the New Keynesian Phillips Curve,” Journal of Money, Credit and Banking, 46 (1), 79–114.

Monacelli, T. (2005) “Monetary Policy in a Low Pass-through Environment,” Journal of Money, Credit and Banking, 1047–1066.

Obstfeld, Maurice and Kenneth Rogoff (2002) “Global Implications of Self-Oriented National Monetary Rules*,” The Quarterly Journal of Economics, 117 (2), 503–535, 10.1162/003355302753650319.

Pappa, Evi (2004) “Do the ECB and the fed really need to cooperate? Optimal monetary policy in a two-country world,” Journal of Monetary Economics, 51 (4), 753–779, 10.1016/j.jmoneco.2003.06.006.

Ravenna, Federico and Carl Walsh (2006) “Optimal monetary policy with the cost channel,” Journal of Monetary Economics, 53 (2), 199–216.

Ravina, Enrichetta (2005) “Habit persistence and keeping up with the Joneses: evidence from micro data,” NYU Working Paper No. FIN-05-046.

Ravn, Morten O, Stephanie Schmitt-Grohe, and Martin Uribe (2007) “Pricing to habits and the law of one price,” American Economic Review, 97 (2), 232–238.

Ravn, Morten O., Stephanie Schmitt-Grohe, Mart´ ın Uribe, and Lenno Uuskula (2010) “Deep habits and the dynamic effects of monetary policy shocks,” Journal of the Japanese and International Economies, 24, 236–258.

Ravn, Morten O., Stephanie Schmitt-Groh´ e, and Mart´ ın Uribe (2012) “Consumption, government spending, and the real exchange rate,” Journal of Monetary Economics, 59 (3), 215–234, 10.1016/j.jmoneco.2012.02.001.

Ravn, Morten, Stephanie Schmitt-Groh´ e, and Martin Uribe (2006) “Deep Habits,” Review of Economic Studies, 73 (1), 195–218, 10.1111/j.1467-937x.2006.00374.x.

Rotemberg, Julio J (1982) “Sticky Prices in the United States.,” Journal of Political Economy, 90, 1187–1211.

Rotemberg, Julio J. and Michael Woodford (1999) “Chapter 16 The cyclical behavior of prices and costs,” in Handbook of Macroeconomics, 1, 1051–1135: Elsevier, https://doi.org/10.1016/S1574-0048(99)10024-7.

Smets, Frank and Rafael Wouters (2007) “Shocks and Frictions in US Business Cycles: A Bayesian DSGE Approach,” American Economic Review, 97 (3), 586–606, 10.1257/aer.97.3.586.

Woodford, M. (2003a) Interest and prices: Foundations of a theory of monetary policy: Princeton Univ Pr.

Woodford, Michael (2003b) “Optimal Interest-Rate Smoothing,” The Review of Economic Studies, 70 (4), 861–886, 10.1111/1467-937X.00270.

Zubairy, Sarah (2014) “On fiscal multipliers: estimates from a medium scale dsge model,” International Economic Review, 55 (1), 169–195, https://doi.org/10.1111/iere.12045.