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The research catalogue is an archive of ESRC-funded grants and outputs. Links, files and other content will no longer be maintained or updated after April 2014.

Monetary and Fiscal Policy Rules with Labour Market and Financial Frictions

Grant reference: RES-062-23-2451

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Conference paper/presentation details

Deep versus superficial habit and the fiscal stimulus
In Dynamic Stochastic General Equilibrium (DSGE) models, the widespread assumption that agents form internal or external habit in consuming a composite good has the consequence of altering the transmission mechanism of shocks as it changes how aggregate demand and labour supply react to innovations. While internal habit capture inertia or persistence in consumption, external habit capture preference interdependence across households (i.e. keeping up with the Joneses). Ravn et al. (2006) introduce the idea that agents may form habit not on the overall consumption level, but separately over a continuum of varieties of goods. In the literature the former type of habit is also known as superficial while the latter as deep. This difference of whether agents form habit on a composite good or on categories of goods has important consequences for the propagation mechanism of macroeconomic shocks. The contribution of this paper is twofold. First, from a positive viewpoint, we compare the two forms of habit and we estimate a New Keynesian model augmented with superficial or deep habit formation and provide empirical support in favour of the deep form of habit. The two estimated models are then used to study the implications of the two competing forms of habit for a fiscal stimulus. Second, from a normative viewpoint, we show that the monetary policy stance is an important determinant of the fiscal multiplier and hence the design of the optimal response of monetary policy to a fiscal stimulus under the two habit specifications.

Primary contributor

Author Cristiano Cantore

Additional contributors

Contributor Paul Levine
Contributor Giovanni Melina
Contributor Bo Yang

Additional details

14 September 2012
Centre for International Macroeconomic Studies (CIMS) conference : monetary and fiscal policy rules with labour market and financial frictions
14 September 2012