July 2004

Does Monetary Policy Keep Up with the Joneses? Optimal Interest-Rate Smoothing with Consumption Externalities

Sanjay K. Chugh


Changes in monetary policy are typically implemented gradually, an empirical observation known as interest-rate smoothing. We propose the explanation that time-non-separable preferences may render interest-rate smoothing optimal. We find that when consumers have "catching-up-with-the-Joneses" preferences, optimal monetary policy reacts gradually to shocks to prevent inefficiently fast adjustments in consumption. We also extend our basic model to investigate the effects of capital formation and nominal rigidities on the dynamics of optimal monetary policy. Optimal policy responses continue to be gradual in the presence of capital and sticky prices, with a size and speed that are in line with empirical findings for the U.S. economy. Our results emphasize that gradualism in monetary policy may be needed simply to guide the economy on an optimally smooth path.

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Keywords: Optimal monetary policy, habit persistence, catching up with the Joneses

PDF: Full Paper

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Last Update: January 11, 2021