The Korean Economic Review
Discretion versus Inflation Targeting in Economies with Relative Habit Persistence
Yongseung Jung (Kyung Hee University)Year 2016Vol. 32No. 1
This paper sets up a canonical new Keynesian model with habit persistence inconsumption. The paper estimates key parameters using maximum likelihood and showsthat the habit persistence improves the explanatory power of the model over the businesscycle, irrespective of habit formation way. If the distortions associated with external habitare not completely eliminated by the fiscal policy, then the remaining external habit entailsa gap between the private marginal rate of substitution between consumption and labor andthe social marginal rate of substitution, generating an endogenous trade-off between thestabilization of welfare-relevant output gap and inflation. Under this circumstance,discretion, partially taking into account the trade-off between output gap and inflation, canbe better than a strict inflation targeting rule in welfare dimension if the fiscal authoritydoes not implement any tax policy to eliminate the distortions associated with external habit.The monetary policy to deal with distortions associated with external habit is less effective inthe ratio external habit model than in the difference habit model, resulting in a higher theinflation rate in the ratio external habit model than the inflation rate in the difference habitmodel.