Habit persistence and optimal interest-rate smoothing

Changes in monetary policy are typically implemented gradually, an empirical observation known as interest-rate smoothing. We propose an explanation of optimal interest-rate smoothing by applying the recent lesson from the related literature on the monetary transmission mechanism that time-non-separable preferences may be key to understanding dynamics in a monetary economy. We find that when consumers have "catching-up-with-the-Joneses" preferences, optimal monetary policy does react gradually to exogenous shocks in order to prevent overheating of the economy. In addition, the Friedman Rule is sub-optimal because the inflation tax reduces the distortion caused by the externality. We also extend our basic model to investigate the effects of capital formation and staggered price-setting on the dynamics of optimal monetary policy. Abstracting from capital formation but introducing staggered price-setting, dynamic optimal policy is largely unchanged. Allowing for capital formation but with prices flexible, optimal policy becomes excessively gradual in the absence of adjustment costs of capital. When both staggered price-setting and capital formation are present, optimal policy again matches fairly well the size and speed of nominal interest-rate adjustments found in U.S. data. Our results emphasize that interest-rate smoothing may be needed simply to guide the economy to an optimally smooth path and need not arise because of uncertainty on the part of policy-makers about the state of the economy, which has been one of the main explanations offered for gradualism.