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 that incorporates deep habits in consumption and investigates the macroeconomic dynamics under the optimal coordinated monetary policy. We show that in response to the structural shocks, the central bank changes the interest rate significantly in the two-country open economy model compared with the closed economy where the central bank is reluctant to move interest rates. When a deep consumption habit exists, the international central bank can exploit the terms of trade externalities. Habit formation might boost the expenditure switching effect, which differentiates the aggressiveness of the central bank between closed and open economies with deep habit. Moreover, we showed that the deviations from the law of one price, or the goods-specific real exchange rate, generated endogenously by the deep habit are significantly related to the degree of home bias. In particular, the deviations fully disappeared when there is no home bias.

• 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

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