Optimal monetary policy in a New Keynesian model with habits in consumption

In this paper we consider the implications of habits for optimal monetary policy, when those habits either exist at the level of the aggregate basket of consumption goods (‘superficial’ habits) or at the level of individual goods (‘deep’ habits: see Ravn et al., 2006). External habits generate an additional distortion in the economy and create new trade-offs for optimal policy, as the policy maker does not respond as aggressively to technology shocks in order to avoid exacerbating the habits externality. This can dramatically affect both the parameterization of optimal simple rules, as well as their determinacy properties. These effects are particularly strong when habits are of the deep kind.

► Different forms of consumption habits have profound implications for optimal policy. ► Habits externalities generate new trade-offs for optimal policy. ► The policy response to technology shocks is muted in the presence of external habits. ► The coefficients of optimal policy rules are deeply affected by the form of habits. ► Consumption habits can overturn familiar determinacy conditions for simple rules.