Habit Formation in Consumption and Its Implications for Monetary Policy Models

This paper explores a monetary policy model with habit formation for consumers, in which consumers’ utility depends in part on current consumption relative to past consumption. The empirical tests developed in the paper show that one can reject the hypothesis of no habit formation with tremendous confidence, largely because the habit formation model captures the gradual hump-shaped response of real spending to various shocks. The paper then embeds the habit consumption specification in a monetary policy model and finds that the responses of both spending and inflation to monetary policy actions are significantly improved by this modification. (JEL D12, E52, E43) Forthcoming, American Economic Review, June 2000. With the resurgence of interest in the effects of monetary policy on the macroeconomy, led by the work of the Christina D. and David H. Romer (1989), Ben S. Bernanke and Alan S. Blinder (1992), Lawrence J. Christiano, Martin S. Eichenbaum, and Charles L. Evans (1996), and others, the need for a structural model that could plausibly be used for monetary policy analysis has become evident. Of course, many extant models have been used for monetary policy analysis, but many of these are perceived as having critical shortcomings. First, some models do not incorporate explicit expectations behavior, so that changes in policy (or private) behavior could cause shifts in reduced-form parameters (i.e., the critique of Robert E. Lucas 1976). Others incorporate expectations, but derive key relationships from ad hoc behavioral assumptions, rather than from explicit optimizing problems for consumers and firms (Fuhrer and George R. Moore 1995b is an example). Explicit expectations and optimizing behavior are both desirable, other things equal, for a model of monetary analysis. First, analyzing potential improvements to monetary policy relative to historical policies requires a model that is stable across alternative policy regimes. This underlines the importance of explicit expectations formation. Second, the “optimal” in optimal monetary policy must ultimately refer to social welfare. Many have approximated social welfare with weighted averages of output and inflation variances, but one cannot know how good these approximations are without more explicit modeling of welfare. This implies that the model be closely tied to the underlying objectives of consumers and firms, hence the emphasis on optimization-based models. A critical test for whether a model reflects underlying objectives is its ability to accurately reflect the dominant dynamic interactions in the data. A number of recent papers (see, for example, Robert G. King and Alexander L. Wolman (1996), Bennett T. McCallum and Edward Nelson (1999a, 1999b); Julio R. Rotemberg and Michael Woodford (1997)) have developed models that incorporate explicit expectations, optimizing behavior, and frictions that allow monetary policy to have real effects. This paper continues in that line of research by documenting the empirical importance of a key feature of aggregate data: the “hump-shaped,” gradual response of spending and inflation to shocks. It then develops a monetary policy model that can capture this feature, as well as all of the features (e.g. the real effects of monetary policy, the persistence of inflation and output) embodied in earlier models. The key to the model’s success on the spending side is the inclusion of habit formation in the consumer’s utility function. This modification