Download Deep Habits

‘’Deep Habits’’ by Morten Ravn, Stephanie
Schmitt Grohe and Martin Uribe
Ester Faia, Universitat Pompeu Fabra
IMOP/ ECB Dynamic Macroeconomic
Conference,
Hydra, 11 June 2005
The scope of the paper
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Embed habit formation for varieties into a dynamic general
equilibrium model
Analytically this has two effects:
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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
The main channels of shock propagation
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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.
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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.
How does this channel modifies the real
business cycle model?
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It amplifies output, employment and real wages fluctuations
adding endogenous business cycles
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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
Is the model compatible with labour market
fluctuations?
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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
Deep habits together with nominal frictions
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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
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
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Do ``deep habits´´ help explain inflation persistence under
nominal frictions?
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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
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The effects of government expenditure shock
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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?
Implications for optimal monetary and fiscal policy
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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?
Conclusions
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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.