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:

– But, no supply side effects! Demand function for good i as in a model without habits:

where

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

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;

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

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)

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

Aggregate Dynamics

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:i) Procyclical real wages

ii) Consumption increase with expenditure shocks

Extensions• Isolating each of the deep habits’ effects:

– Price elasticity effect:

– Intertemporal effect:

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).