Habit Persistence in Consumption in a Sticky Price Model of the Business Cycle

This paper examines the role of habit persistence in consumption in explaining persistent responses of inflation and output to money growth shocks. A MIU-model with a separable utility function is embedded into a stochastic DGE model with sticky prices. It is shown that for a high degree of habit persistence consumption displays a pronounced and hump-shaped response while the volatility falls short empirical estimates. The behavior of output and inflation does not change compared to a model without habit formation. Empirically plausible degrees of habit persistence still cause consumption to be persistent but do not improve the performance for other macroeconomic aggregates. Most variables are cyclical and too strongly correlated with output. Overall habit persistence in consumption cannot explain the observed reaction of the macroeconomic aggregates to monetary shocks.