We use a micro-founded macroeconometric modeling framework to investigate the design of monetary policy when the central bank faces uncertainty about the true structure of the economy. We apply Bayesian methods to estimate the parameters of the baseline specification using postwar U.S. data and then determine the policy under commitment that maximizes household welfare. We find that the performance of the optimal policy is closely matched by a simple operational rule that focuses solely on stabilizing nominal wage inflation. Furthermore, this simple wage stabilization rule is remarkably robust to uncertainty about the model parameters and to various assumptions regarding the nature and incidence of the innovations. However, the characteristics of optimal policy are very sensitive to the specification of the wage contracting mechanism, thereby highlighting the importance of additional research regarding the structure of labor markets and wage determination.

We examine the relationship between income growth and saving using both cross-country and household data. At the aggregate level, we find that growth Granger causes saving, but saving does not Granger cause growth. Using household data, we find that households with predictably higher income growth save more than households with predictably low growth. We argue that standard permanent income models of consumption cannot explain these findings, but, a model of consumption with habit formation may. The positive effect of growth on saving implies that previous estimates of the effect of saving on growth may be overstated.

We propose a model of consumption and saving based on Kahneman and Tversky's Prospect Theory that implies a fundamental asymmetry in consumption behavior inconsistent with other models of consumption. When there is sufficient income uncertainty, a person resists lowering consumption in response to bad news about future income. This resistance is greater than the resistance to increasing consumption in response to good news. We present empirical evidence from

The paper generalizes the Grossman and Laroque (1990) model of optimal consumption and portfolio allocation in the context in which a durable good (or house) subject to adjustment costs is both an argument of the utility function and a component of wealth. Because the Grossman and Laroque model abstracts completely from nondurable consumption, their analysis cannot address either a) the potential spillover effects of the adjustment costs of the durable good on the dynamics of nondurable consumption, or b) the implications for portfolio allocation of housing risk arising from variation in the relative price of housing. By introducing an endogenously determined but infrequently adjusted state variable, the housing model generates many of the implications of the habit persistence model, such as smooth nondurable consumption, state-dependent risk aversion, and a small elasticity of intertemporal substitution despite moderate risk aversion. Using a specification of the utility function which nests both the housing model and habit persistence, the Euler equation for nondurable consumption is estimated with household level data on food consumption and housing from the PSID. The habit persistence model (without housing effects) can be decisively rejected, while the housing model

This paper explores the household behavior that underlies the link between wealth and consumption at the aggregate level. One possibility is that changes in wealth directly cause changes in consumption through their effect on households ’ contemporaneous budget sets; another possibility is that they merely predict changes in consumption because they signal changes in future income. Previous attempts to assess the relative importance of these “direct” and “indirect ” channels have yielded indeterminate results. Based on analysis of householdlevel data from the Consumer Expenditure Survey, we find that direct wealth effects begin to show up relatively quickly and continue to boost consumption growth for a number of quarters, in line with aggregate estimates. In contrast, we find that the indirect wealth channel is not an important determinant of consumption growth. We also estimate that an additional dollar of wealth leads households with moderate securities holdings to increase consumption between 5 cents and 15 cents, with the most likely gain in the lower part of this range. Much of this paper was completed while Maki was an economist at the Federal Reserve Board. We wish to thank Byron Lutz, Shital Patel, and Richard Saouma for excellent research assistance

In earlier work (Fuhrer 1996), I document what I view as the failure of standard models of representative consumer and firm behavior to replicate the dynamics that we observe in the aggregate data. In essence, these models fail because they imply that both inflation and real variables must “jump” in response to monetary policy (and other) shocks, in contrast to identified VAR evidence that shows a gradual, “hump-shaped” response. This paper discusses a rigorous empirical standard for monetary policy models. The motivation for this discussion is that, if one wishes to conduct welfare analysis, one must be reasonably confident that the model provides a good approximation to underlying consumer and firm behavior over the monetary policy horizon, i.e., in the short-run. The paper examines a specific alternative to the standard consumption model in which consumers ’ utility depends in part on current consumption relative to past consumption. This formulation of habit formation allows one to nest habit formation, life-cycle consumption, and Campbell and Mankiw’s “rule-of-thumb” consumers within a more general model. The empirical tests developed in the paper show that one can reject the hypothesis of no habit formation with tremendous confidence. This result suggests that models that are unable to produce a hump-shaped response will be strongly rejected empirically.

This paper provides derivations necessary for solving an optimal consumption problem with multiplicative habits and a CRRA ‘outer ’ utility function, either for a microeconomic problem with both labor income risk and rate-of-return risk, or for a macroeconomic representative agent model. Keywords: agent habit formation, relative consumption, economic growth, representative

This paper develops a new method of estimating risk aversion using data on labor supply behavior. In particular, I show that existing evidence on labor supply behavior places a tight upper bound on risk aversion in the expected utility model. I derive a formula for the coefficient of relative risk aversion ( ) in terms of (1) the ratio of the income elasticity of labor supply to the wage elasticity and (2) the degree of complementarity between consumption and labor. I bound the degree of complementarity using data on consumption choices when labor supply varies randomly across states. Using labor supply elasticity estimates from thirty-three studies, I find a mean estimate of 1: I then show that generating> 2 would require that wage increases cause sharper reductions in labor supply than estimated in any of the studies.

We estimate the degree of ‘stickiness ’ in aggregate consumption growth (sometimes interpreted as reflecting consumption habits) for thirteen advanced economies. We find that, after controlling for measurement error, consumption growth has a high degree of autocorrelation, with a stickiness parameter of about 0.7 on average across countries. The sticky-consumption-growth model outperforms the random walk model of Hall (1978), and typically fits the data better than the popular Campbell and Mankiw (1989) model. In several countries, the sticky-consumption-growth and Campbell–Mankiw models work about equally well.

We develop an external habit persistence model where the time series of the aggregate portfolio and the cross section of stock returns are simultaneously studied and tested. By applying a slightly modified version of the model of Campbell and Cochrane (1999), we obtain closed form solutions for individual securities prices and returns and a full characterizations of the dynamics of the risk-return characteristics of individual securities. We find that each stock return “beta” with respect to the total wealth portfolios is jointly determined by an aggregate variable that depends on the habit level, and an idiosyncratic asset characteristics that depends on the contribution of the security to total consumption relative to its long-run average contribution. This functional form imposes tight predictions on the cross sectional test, including sign and magnitude of the coefficients, and insures that the explanatory power of the beta comes from the predictable part of the realization of returns. An estimate of the model for a set of 20 industry portfolios is able to explain cross-sectional variation in the conditional expected returns. Moreover, the model generates price consumption ratios for individual industries that track well the empirical ones.