Working Paper: NBER ID: w12731
Authors: Morten Ravn; Stephanie Schmitt-Grohe; Martin Uribe
Abstract: This paper proposes a novel international transmission mechanism based on the assumption of deep habits. The term deep habits stands for a preference specification according to which consumers form habits on a good-by-good basis. Under deep habits, firms face more elastic demand functions in markets where nonhabitual demand is high relative to habitual demand, creating an incentive to price discriminate. We refer to this type of price discrimination as pricing to habits. In the presence of pricing to habits, innovations to domestic aggregate demand induce a decline in markups in the domestic country but not abroad, leading to a departure from the law of one price. In this way, the proposed pricing-to-habit mechanism can explain the observation that prices of the same good across countries, expressed in the same currency, vary over the business cycle. Furthermore, it can account for the empirical fact that in response to a positive domestic demand shock, such as an increase in government spending, the real exchange rate depreciates, domestic consumption expands, and the trade balance deteriorates.
Keywords: pricing to habits; law of one price; international economics; demand shocks; deep habits
JEL Codes: E3; F4
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Domestic government spending increase (H56) | Domestic markups decline (D49) |
| Domestic government spending increase (H56) | Foreign markups increase (F69) |
| Domestic government spending increase (H56) | Divergence from the law of one price (F16) |
| Positive domestic demand shocks (E39) | Real exchange rate depreciates (F31) |
| Positive domestic demand shocks (E39) | Domestic consumption expands relative to foreign consumption (E20) |
| Positive domestic demand shocks (E39) | Trade balance deteriorates (F14) |
| Domestic demand shocks (D12) | Prices vary across countries (P22) |
| Pricing to habits (D49) | Firms adjust pricing strategies (L11) |