Consumption Externalities and Monetary Policy With Limited Asset Market Participation

Abstract

This article explores the interaction between consumption externalities and limited asset market participation (LAMP) in the standard New-Keynesian model. We assess the performance of simple Taylor-type interest rate rules with respect to (a) equilibrium determinacy, (b) the model's ability to simultaneously generate output and inflation volatility similar to the pre-Volcker era, and (c) the model's response to a technology shock. We find that when individual preferences are affected by average household consumption (Aggregate Consumption Externality), stronger externalities increase the range of LAMP for which multiple equilibria arise even if the policy rule satisfies the Taylor principle. The interaction of LAMP and externalities can generate vast inflation/output relative volatility in line with the one observed in the data in the 1970s. According to our analysis, consumption externalities also affect the responses of endogenous variables to total factor productivity shocks. (JEL E4, E5)

Income Redistribution, Consumer Credit, and Keeping Up with the Riches

“…11. Similar specifications of relative consumption motives are used by Airaudo and Bossi (2017) and Alvarez-Cuadrado and Japaridze (2017). They study how consumption externalities affect the impact of monetary policy and financial deregulation, respectively.…”