Habit formation, asymmetric price adjustment, and real exchange rate persistence

Abstract

This paper studies the eect of habit formation in consumption on the real exchange persistence under monetary policy shocks. Closed economy models of monetary policy have emphasized the ability of habit formation to generate endogenous persistence, which has encouraged the open economy literature to incorporate habit formation into theoretical models to generate greater persistence in the real exchange rate. However, there has not yet been a thorough evaluation of the habit formation eect in the real exchange rate context. By incorporating habit formation into the model of Benigno (2004), it is shown that the habit formation eect depends on the degree of price stickiness assumed within and across countries as well as the design of the monetary policy rule. Habit formation does not aect the dynamics of the real exchange rate under symmetric price adjustment and does not signicantly contribute to the persistence of the real exchange rate for more general cases.