Monetary policy with non-homothetic preferences (original) (raw)

This paper studies the role of non-homothetic preferences for monetary policy from both a positive and a normative perspective. It draws on a dynamic stochastic general equilibrium model characterized by preferences with a variable elasticity of substitution among goods and with price adjustment costs à la Rotemberg. These preferences-introduced by Cavallari and Etro (2017) in a setup with ‡exible prices-have remarkable implications for monetary policy. Three main results stand out from a comparison of models with an increasing and a constant elasticity. First, an increasing elasticity induces novel intertem-poral substitution e¤ects that amplify the propagation of monetary and technology shocks. Second, it weakens the ability of a simple Taylor rule to attain a given level of macroeconomic stabilization. Third, the smallest welfare losses can be attained by stabilizing both in ‡ation and output, in contrast to the prevailing view-based on models with a constant elasticity-that the best thing the monetary authority can do is to control in ‡ation only.