Consumption Growth and the Real Interest Rate following a Monetary Policy Shock : Is the Habit Persistence Assumption Relevant?

Abstract

In this paper, we study the role of habit formation in accounting for the joint behavior of the real interest rate and consumption growth following a contractionary monetary policy shock, the real interest rate exhibits a persistent increase while consumption growth drops persitently. As the standard permanent income model is known to be unable to replicate this co-movement for intertemporal substitution motives, we introduce habit persistence in consumption behavior. We test the implied Euler equation using a method of moments on conditional moments (IRF) obtained from the VAR Model. Our estimates of the habit persistence parameter are similar to previous results in the literature. Further, we find empirical support in favor of habit formation as a relevant assumption to represent the joint behavior of the real interest rate and the consumption growth following a monetary policy shock. Finally, we show that habit formation allows weakening the intertemporal substitution mechanismhabit persistence, consumption growth, real interest rate, vector autoregressive, monetary policy shock