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Deep Habits Morten Ravn (EUI) Stephanie Schmitt-Grohé (Duke) Martín Uribe (Duke)

Deep Habits Morten Ravn (EUI) Stephanie Schmitt-Grohé (Duke) Martín Uribe (Duke). Existing Literature. Habits are formed at the level of an aggregate good. (Superficial Habits) Has demand side effect Euler equation:

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Deep Habits Morten Ravn (EUI) Stephanie Schmitt-Grohé (Duke) Martín Uribe (Duke)

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  1. Deep HabitsMorten Ravn (EUI)Stephanie Schmitt-Grohé (Duke)Martín Uribe (Duke)

  2. Existing Literature • Habits are formed at the level of an aggregate good. (Superficial Habits) • Has demand side effect Euler equation: • But, no supply side effects! Demand function for good i as in a model without habits: where

  3. Deep Habits • This paper: Habits are formed at the level of individual goods. • Demand side (Euler equation) is identical under deep and superficial external habits. • However, supply side of the economy changes in fundamental ways: two implications where

  4. Price-elasticity Effect (I) • Demand now has 2 components: one is price elastic and one is price inelastic; • Price elasticity of demand for each good is increasing in aggregate demand (xt). • Price elasticity procyclical;

  5. Price-elasticity Effect (II) • Fact: price mark-ups are inversely related to price elasticity of demand; • This implies that the behavior of mark-ups is countercyclical! • This is in line with empirical evidence

  6. Intertemporal Effect • Under deep habits firm´s pricing problem becomes dynamic: • each current unit of good i sold will affect its future sales (magnitude of effect depends on the interest rate)

  7. Fully-fledged Model • Slow decay in habits: • capital accumulation • introduce government (budget entirely financed by lump-sum taxes) -government consumption is subject to deep habit formation

  8. Aggregate Dynamics

  9. Main Results • As stated in the equilibrium conditions, deep habits cause the price elasticity of demand to be procyclical (hence mark-ups to be countercyclical); • This implies: • Procyclical real wages • Consumption increase with expenditure shocks

  10. Extensions • Isolating each of the deep habits’ effects: • Price elasticity effect: • Intertemporal effect:

  11. Conclusions • Deep habit formation implies that producers face demand functions that depend on past sales, inducing a theory of endogenous markup determination. • Under deep habits markups are countercyclical, which is in line with empirical evidence. • This has implications on the impulse responses of wages and private consumption to an exogenous government expenditures shock: both variables increase, which is also in line with the data (Gali et al., 2003; Blanchard and Perotti, 2002; Fatás and Mihov, 2001).

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