‘’Deep Habits’’ by Morten Ravn, Stephanie Schmitt Grohe and Martin Uribe

1. Ester Faia, Universitat Pompeu Fabra IMOP/ ECB Dynamic Macroeconomic Conference, Hydra, 11 June 2005 ‘’Deep Habits’’ by Morten Ravn, Stephanie Schmitt Grohe and Martin Uribe

2. The scope of the paper • Embed habit formation for varieties into a dynamic general equilibrium model • Analytically this has two effects: • Demand side: each variety depends on past levels as in the model with superficial habits • Supply side: time varying wedge between marginal product and marginal cost of labour (the mark-up) • The goal is to replicate two main stylized facts: • Countercyclical mark-ups • Pro-cyclical real wages and co-movements between employment and output • Consumption demand rises in response to government expenditure shocks

3. The main channels of shock propagation • Price-elasticity effect: as demand for single variety rises the price elastic term increases relatively to the habitual term hence total demand elasticity rises => mark-up decreases. - This effect distinguishes deep habits from superficial habits. • The inter-temporal effect: if firms expect a future increase in demand they have an incentive to reduce mark-ups today to increase customer base. - This effect distinguishes deep habits from other theories of endogenous mark-up.

4. How does this channel modifies the real business cycle model? • It amplifies output, employment and real wages fluctuations adding endogenous business cycles • Demand rises, mark-up falls hence demand rises again • If the wedge between marginal product and marginal cost of labour falls labour demand rises. • It overturns consumption fluctuations under government expenditure shocks => it introduces a keynesian wealth effect which counteracts the crowding out effect

5. Is the model compatible with labour market fluctuations? • Wages and labour productivity are pro-cyclical but not so much pro-cyclical • Real business cycle models, sticky prices and matching frictions models have all been criticized because real wages were too responsive to aggregate shocks. • Wages stickiness is the most obvious way to amend this counterfactual feature. • In general RSGU should report more statistics concerning labour market variables

6. Deep habits together with nominal frictions • If demand falls and prices are sticky firms accommodate the reduction in demand by cutting real wages (even more under deep habits) • Real wage sensitivity is transferred to marginal costs and inflation • This contrasts with strong empirical evidence on inflation persistence

7. The implications for financial markets The endogenous mark-up also introduces a wedge between the marginal product and the marginal cost of capital hence it should also amplify asset return fluctuations Additionally if one introduces a market for firms shares the value of a firm would vary endogenously with the mark-up => This is an alternative way to introduce endogenous asset price fluctuations

8. Do ``deep habits´´ help explain inflation persistence under nominal frictions? • Deep habits in a sticky price model produce the following Phillips curve: • Inflation persistence arises from the dependence with past output => BUT this is so even in the case of superficial habits where stickiness in demand reduces the elasticity of marginal costs (hence of inflation) to output. • Inflation inertia is also generated with ``rule of thumb producer´´ = > we need identifying whether inflation inertia is obtained through the introduction of past inflation or past output. • Hence: the identification of alternative models is probably very weak=> it depends on the shape of the lag structure

9. The effects of government expenditure shock • In response to government expenditure shocks deep habits generate an increase in private consumption => increase in real wages adds a keynesian wealth effect which overturn the crowding out • However the same effect is obtained by postulating incomplete markets (see Gali´, Lopez- Salido and Valles) => agents only consume their labour income. • How do we identify the ultimate cause of the increase in private consumption?

10. Implications for optimal monetary and fiscal policy • The model introduces a time-varying wedge on labour and capital • This might clearly have implications for optimal monetary and fiscal policy • Would it be optimal to tax capital to offset the time-varying wedge on investment?

11. Conclusions • An interesting and carefully done analysis with many extensions • It is necessary to explore further the implications labour market variables and inflation to see whether deep habits fully satisfy empirical evidence • I believe it is worth exploring implications for financial markets and optimal policy.