Reference-dependent Preferences and the Transmission of Monetary Policy

E. Gaffeo, I. Petrella, D. Pfajfar, E. Santoro

Research output: Working paperDiscussion paperOther research output

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Abstract

This paper proposes a novel explanation of the vast empirical evidence showing that output and prices react asymmetrically to monetary policy innovations over contractions and expansions in the business cycle. We use VAR techniques to show that monetary policy exerts stronger e¤ects on the U.S. GDP during contractionary phases, as compared to expansionary ones. As to prices, their response is not statistically different across different cyclical stages. We show that these facts are consistent with a New Neoclassical Synthesis model based on the assumption that households' utility partly depends on deviations of their consumption from a reference level below which aversion to loss is displayed. In line with the theory developed by Kahneman and Tversky (1979), losses in consumption utility loom larger than gains. This implies state-dependent degrees of real rigidity and elasticity of intertemporal substitution in consumption that generate competing effects on the responses of output and inflation following a monetary innovation. The key predictions of the model are in line with the data. We then explore the state-dependent trade-off between inflation and output stabilization that naturally arises in this context. Greater elasticity of inflation to real activity during expansionary stages of the cycle promotes a stronger degree of policy activism in the response to the expected rate of inflation under discretion, compared to what is otherwise prescribed during contractions.
Original languageEnglish
Place of PublicationTilburg
PublisherMacroeconomics
Number of pages35
Volume2010-111
Publication statusPublished - 2010

Publication series

NameCentER Discussion Paper
Volume2010-111

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Reference-dependent preferences
Inflation
Monetary policy
Contraction
Elasticity
Real activity
Elasticity of intertemporal substitution
Deviation
Price response
Prediction
Policy innovation
Trade-offs
Activism
Household
Empirical evidence
Loom
Business cycles
Real rigidities
Innovation
Discretion

Keywords

  • Reference-dependent Preferences
  • Asymmetry
  • Monetary policy.

Cite this

Gaffeo, E., Petrella, I., Pfajfar, D., & Santoro, E. (2010). Reference-dependent Preferences and the Transmission of Monetary Policy. (CentER Discussion Paper; Vol. 2010-111). Tilburg: Macroeconomics.
Gaffeo, E. ; Petrella, I. ; Pfajfar, D. ; Santoro, E. / Reference-dependent Preferences and the Transmission of Monetary Policy. Tilburg : Macroeconomics, 2010. (CentER Discussion Paper).
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Gaffeo, E, Petrella, I, Pfajfar, D & Santoro, E 2010 'Reference-dependent Preferences and the Transmission of Monetary Policy' CentER Discussion Paper, vol. 2010-111, Macroeconomics, Tilburg.

Reference-dependent Preferences and the Transmission of Monetary Policy. / Gaffeo, E.; Petrella, I.; Pfajfar, D.; Santoro, E.

Tilburg : Macroeconomics, 2010. (CentER Discussion Paper; Vol. 2010-111).

Research output: Working paperDiscussion paperOther research output

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AB - This paper proposes a novel explanation of the vast empirical evidence showing that output and prices react asymmetrically to monetary policy innovations over contractions and expansions in the business cycle. We use VAR techniques to show that monetary policy exerts stronger e¤ects on the U.S. GDP during contractionary phases, as compared to expansionary ones. As to prices, their response is not statistically different across different cyclical stages. We show that these facts are consistent with a New Neoclassical Synthesis model based on the assumption that households' utility partly depends on deviations of their consumption from a reference level below which aversion to loss is displayed. In line with the theory developed by Kahneman and Tversky (1979), losses in consumption utility loom larger than gains. This implies state-dependent degrees of real rigidity and elasticity of intertemporal substitution in consumption that generate competing effects on the responses of output and inflation following a monetary innovation. The key predictions of the model are in line with the data. We then explore the state-dependent trade-off between inflation and output stabilization that naturally arises in this context. Greater elasticity of inflation to real activity during expansionary stages of the cycle promotes a stronger degree of policy activism in the response to the expected rate of inflation under discretion, compared to what is otherwise prescribed during contractions.

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Gaffeo E, Petrella I, Pfajfar D, Santoro E. Reference-dependent Preferences and the Transmission of Monetary Policy. Tilburg: Macroeconomics. 2010. (CentER Discussion Paper).