Pricing to Habits and the Law of One Price

Morten Ravn, Martín Uribe () and Schmitt-Grohé, Stephanie
Authors registered in the RePEc Author Service: Stephanie Schmitt-Grohe

No 6030, CEPR Discussion Papers from C.E.P.R. Discussion Papers

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: Countercyclical markup; Deep habits; Government spending; Law of one price; Real exchange rate (search for similar items in EconPapers)
JEL-codes: E32 F30 F41 (search for similar items in EconPapers)
Date: 2007-01
New Economics Papers: this item is included in nep-cba, nep-ifn and nep-mac
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (25)

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Related works:
Journal Article: Pricing to Habits and the Law of One Price (2007)
Working Paper: Pricing to Habits and the Law of One Price (2006)
Working Paper: Pricing to Habits and the Law of One Price (2006)
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