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Consumption Growth and the Real Interest Rate following a Monetary Policy Shock: Is the Habit Persistence Assumption Relevant?

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  • Stéphane Auray
  • Clémentine Gallès

Abstract

In this paper, we study the role of habit formation in accounting for the joint behavior of the real interest rate and consumption growth following a monetary policy shock. A VAR estimation on US data shows that following a contractionary monetary policy shock, the real interest rate exhibits a persistent increase while consumption growth drops persistently. As the standard permanent income model is known to be unable to replicate this co?movement for intertemporal substitution motives, we introduce habit persistence in consumption behavior. We test the implied Euler equation using a method of moments on conditional moments (IRF) obtained from the VAR model. Our estimates of the habit persistence parameter are similar to previous results in the literature. Further, we find empirical support in favor of habit formation as a relevant assumption to represent the joint behavior of the real interest rate and consumption growth following a monetary policy shock. Finally, we show that habit formation allows weakening the intertemporal substitution mechanism. JEL Classification: E21, E5.

Suggested Citation

  • Stéphane Auray & Clémentine Gallès, 2008. "Consumption Growth and the Real Interest Rate following a Monetary Policy Shock: Is the Habit Persistence Assumption Relevant?," Recherches économiques de Louvain, De Boeck Université, vol. 74(2), pages 121-142.
    • Handle: RePEc:cai:reldbu:rel_742_0121
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    Keywords

    habit persistence; consumption growth; real interest rate; vector autoregressive; monetary policy shock;
    All these keywords.

    JEL classification:

    • E21 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth
    • E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit

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