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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) where – Has demand side effect Euler equation: – But, no supply side effects! Demand function for good i as in a model without habits: Deep Habits • This paper: Habits are formed at the level of individual goods. where – Demand side (Euler equation) is identical under deep and superficial external habits. – However, supply side of the economy changes in fundamental ways: two implications 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) ii) Procyclical real wages 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).