Habit Formation and the Persistence of Monetary Shocks

H. Bouakez, E. Cardia and F. Ruge-Murcia
Journal of Monetary Economics (2005) 52(6), 1073-1088.
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This paper studies the persistent effects of monetary shocks on output.
Previous empirical literature documents this persistence, but standard general equilibrium models with sticky prices fail to generate output responses beyond the duration of nominal contracts. This paper constructs and estimates a general equilibrium model with price rigidities, habit formation, and costly capital adjustment. The model is estimated via Maximum Likelihood using US data on output, the real money stock, and the nominal interest rate. Econometric results suggest that habit formation and adjustment costs to capital play an important
role in explaining the output effects of monetary policy. In particular, impulse response analysis indicates that the model generates persistent, hump-shaped output responses to monetary shocks.