WHAT DO WORKING CAPITAL AND HABIT TELL US ABOUT THE CO-MOVEMENT PROBLEM?

Abstract

Empirical studies find that expenditures on both durable and nondurable goods fall following a contractionary monetary policy shock. However, in standard two-sector models with staggered nondurable goods prices and flexible durable goods prices, consumption of durables rises whereas that of nondurables falls in response to a contractionary policy shock. To resolve this co-movement problem, I extend the model to include a realistic financial friction that firms must pay for their productive inputs prior to production, i.e., working capital, along with habit formation in nondurable goods consumption. Following a positive interest rate shock, the working capital channel raises production costs, thereby discouraging production of both durable and nondurable goods. Furthermore, habit formation induces households to smooth the growth rate of nondurable goods consumption, and hence mitigates the fall in the nondurable goods sector. The model solves the co-movement problem and successfully generates a more sensitive response in the durable goods sector, as observed in the data.