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INTEREST RATE RULES AND EQUILIBRIUM STABILITY UNDER DEEP HABITS

Published online by Cambridge University Press:  17 July 2013

Sarah Zubairy
Sarah Zubairy*
Affiliation:
Bank of Canada and Texas A&M University
*
Address correspondence to: Sarah Zubairy, Department of Economics, Texas A&M University, 4228 TAMU, College Station, TX 77843, USA; e-mail: szubairy@econmail.tamu.edu.
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Abstract

This paper studies the determinacy of equilibrium in a new Keynesian model with deep habits under different interest rate rules. The main finding is that an interest rate rule satisfying the Taylor principle is no longer a sufficient condition to guarantee determinacy. Including interest rate smoothing and a response to output deviations from steady state significantly enlarges the regions of determinacy. However, under all the simple interest rate rules considered, determinacy is not guaranteed for a very high degree of deep habits. Deep habits give rise to countercyclical markups, which is in line with empirical evidence and makes them an appealing feature in the study of demand shocks. The countercyclicality of markups also leads to multiple equilibria because of self-fulfilling expectations for a high degree of deep habit formation.

Keywords

Taylor PrincipleInterest Rate RulesSticky PricesDeep Habits
Type
Articles
Information
Macroeconomic Dynamics , Volume 18 , Issue 1 , January 2014 , pp. 23 - 40
Copyright
Copyright © Cambridge University Press 2013 

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