Business Cycle Implications of Internal Consumption Habit for New Keynesian Models

Takashi Kano and James M. Nason
Working Paper 2009-16
July 2009

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This paper studies the implications of internal consumption habit for propagation and monetary transmission in New Keynesian dynamic stochastic general equilibrium (NKDSGE) models. We use Bayesian methods to evaluate the role of internal consumption habit in NKDSGE model propagation and monetary transmission. Simulation experiments show that internal consumption habit often improves NKDSGE model fit to output and consumption growth spectra by dampening business cycle periodicity. Nonetheless, habit NKDSGE model fit is vulnerable to nominal rigidity, the choice of monetary policy rule, the frequencies used for evaluation, and spectra identified by permanent productivity shocks.

JEL classification: E10, E20, E32

Key words: habit, New Keynesian, propagation, monetary transmission, Bayesian Monte Carlo

The authors thank Evan Anderson, Heather Anderson, Jeannine Bailliu, Hafedh Bouakez, Toni Braun, Fabio Canova, Youngsung Chang, Richard Dennis, Mick Devereux, Mike Dotsey, Bill Dupor, Martin Fukac, John Geweke, Tasos Karantounias, Thomas Lubik, Christian Matthes, Ricardo Nunes, Adrian Pagan, B. Ravikumar, Pedro Silos, Larry Schembri, Tan Wang, Tao Zha, and seminar and session participants at the Bank of Japan, the Bank of Canada, the 2004 Far Eastern Meetings of the Econometric Society, the Tenth International Conference on Computing in Economics and Finance (July 2004), the 2007 summer meetings of the Econometric Society, HEC Montréal, Hitotsubashi University, the University of Tokyo, Kobe University, the Federal Reserve Bank of Atlanta's macro lunch workshop, Yonsei University, Workshop on Methods and Applications for DSGE Models at the Federal Reserve Bank of Cleveland (October 2008), the Reserve Bank of Australia's 2008 research workshop on monetary policy in open economies, the Federal Reserve Bank of Philadelphia, Northern Illinois University, and the system macro committee's May 2009 meeting at the Federal Reserve Bank of San Francisco for useful discussions. An early version of this paper circulated as "Business Cycle Implications of Internal Habit Formation." Kano thanks the Ministry of Education, Culture, Sports, Science, and Technology of the Government of Japan for support from a grant-in-aid for scientific research (number 20730205). The views expressed here are the authors' and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any remaining errors are the authors' responsibility.

Please address questions regarding content to Takashi Kano, Faculty of Economics, Graduate School of Economics, University of Tokyo, 7–3–1 Hongo, Tokyo, Japan,, or James M. Nason, Research Department, Federal Reserve Bank of Atlanta, 1000 Peachtree Street, N.E., Atlanta, GA 30309-4470,

For further information, contact the Public Affairs Department, Federal Reserve Bank of Atlanta, 1000 Peachtree Street, N.E., Atlanta, Georgia 30309-4470, 404-498-8020.