An Optimising Model for Monetary Policy Analysis: Can Habit Formation Help?

In earlier work (Fuhrer 1997a), I document what I view as the failure of standard models of representative consumer and firm behaviour to replicate the dynamics that we observe in the aggregate data. In essence, these models fail because they imply that both inflation and real variables must ‘jump’ in response to monetary policy (and other) shocks, in contrast to identified VAR evidence that shows a gradual, ‘hump shaped’ response. This paper discusses a rigorous empirical standard for monetary policy models. The motivation for this discussion is that, if one wishes to conduct welfare analysis, one must be reasonably confident that the model provides a good approximation to underlying consumer and firm behaviour over the monetary policy horizon, i.e. in the short run. The paper examines a specific alternative to the standard consumption model in which consumers’ utility depends in part on current consumption relative to past consumption. This formulation of habit formation allows one to nest habit formation, life-cycle consumption, and Campbell and Mankiw’s ‘rule of thumb’ consumers within a more general model. The empirical tests developed in the paper show that one can reject the hypothesis of no habit formation with tremendous confidence. This result suggests that models that are unable to produce a hump-shaped response will be strongly rejected empirically.