Time-Varying Volatility, Precautionary Saving and Monetary Policy

38 Pages Posted: 1 Nov 2011

Date Written: October 31, 2011

Abstract

This paper analyses the conduct of monetary policy in an environment where households’ desire to amass precautionary savings is influenced by fluctuations in the volatilities of disturbances that hit the economy. It uses a simple New Keynesian model with external habit formation that is augmented with demand and supply disturbances whose volatilities vary over time. If volatility fluctuations are ignored by policy, interest rates are set at a suboptimal level. The extent of ‘policy bias’ is relatively small but of greater importance the higher the degree of habit formation. The reason is that habit-forming preferences raise risk aversion, increasing the importance of the precautionary savings channel through which volatility fluctuations impact upon inflation and output.

Keywords: Time-varying volatility, precautionary saving, monetary policy, DSGE models

JEL Classification: E21, E32, E58, G12

Suggested Citation

Hatcher, Michael, Time-Varying Volatility, Precautionary Saving and Monetary Policy (October 31, 2011). Bank of England Working Paper No. 440, Available at SSRN: https://ssrn.com/abstract=1951939 or http://dx.doi.org/10.2139/ssrn.1951939

Michael Hatcher (Contact Author)

Cardiff University ( email )

Aberconway Building
Colum Drive
Cardiff, Wales CF10 3EU
United Kingdom

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